Decentralized finance (DeFi) came with lots of potential and opportunities for participants to earn income. The primary avenue for this is providing liquidity. Anyone with funds can become a liquidity provider for protocols such as Uniswap, Pancakeswap and many others so that they can earn rewards from it.
Indeed, providing liquidity has become a major passive income stream for thousands of people through DeFi, and continues to thrive as a popular way to earn by just becoming a market maker with your crypto assets.
However, there are risks inherent in the process that anyone intending to be a market maker should know about. One of such risks is impermanent loss, which is one of the most important phenomena in the space, as it affects your market making business.
What is Impermanent Loss?
Imagine that you’re using your crypto assets to provide liquidity to a DeFi protocol, say Uniswap. Now because of the intricacies of the market making process, your crypto assets may lose value at the time you wish to withdraw them from the pool you contributed to, as we will see shortly.
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This reduction in the dollar value of the assets at the time you withdraw them compared to when you locked them is called impermanent loss.
The bigger the price difference, the greater the impact of impermanent loss on the assets. This means that stablecoins or wrapped tokens – which stay in a tight price range – are the least likely assets to suffer impermanent loss.
How Impermanent Loss Happens
To gain a better understanding of how impermanent loss works, let’s use a typical example to describe it. Let’s say you’re a market maker and you wish to contribute liquidity to a protocol. Because the deposited assets must be of equal value, let’s say you deposited 1 ETH and 100 USDT, meaning each ETH is worth 100 USDT. That makes your total deposit is worth $200.
In a pool that has a total of 10 ETH and 1,000 USDT, that means you have a 10% stake out of the pool. Now assuming the price of ETH later increased to 400 USDT while you were still in the pool.
If arbitrage traders continue to add more USDT to the pool and remove ETH, the ratio of ETH to USDT in the pool now changes and you have more USDT than ETH, even though you still have the same liquidity of 10,000. Specifically, let’s say the pool now has 5 ETH and 2,000 USDT, but what determines the price of assets in the pool is the ratio of the assets in the pool.
Now assuming you wish to withdraw your assets, we know that 1 ETH is currently worth 400 USDT, but you’re only entitled to 10% of the pool. Therefore instead of withdrawing 1 ETH and 100 USD, you’re now entitled to only 0.5 ETH and 200 USDT. This gives a total value of $400 for you to withdraw. You’ve gained $100 right? Great!
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But let’s check what the value of your initial investment would be by now if you just held your 1 ETH and 100 USDT. You would now have 400 USDT from ETH and your initial 100 USDT, making $500 USDT.
The $100 loss is known as impermanent loss. It is called impermanent because if you left the assets in the pull until the price balanced again, you wouldn’t have incurred the loss.
How to Correct Impermanent Loss
Impermanent loss cannot be prevented in reality, but it can be made up for. Usually, liquidity providers are paid rewards from the transaction fees paid by the protocol users. If you provide liquidity to a protocol with a high transaction volume, your rewards can be enough to not only make up for the impermanent loss, but for you to earn more from providing liquidity than if you just held your assets.
It is always advisable to calculate your impermanent loss before making a decision to withdraw though, since withdrawing at the wrong time can cost you a lot.
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