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What is impermanent loss and how to avoid it?

What is impermanent loss and how to avoid it?

What is impermanent loss and how to avoid it?

What is an impermanent loss in yield farming?

Yield farming, where you lend your tokens for rewards, is directly related to temporary losses. However, it is not the same as staking as investors need to inject funds into the blockchain to validate transactions and blocks in order to earn staking rewards. Rather, yield farming is about lending your tokens to a liquidity pool or providing liquidity. While yield farming is more profitable than holding, offering liquidity has its risks, including and price risks.

The number of liquidity providers and tokens in the liquidity pool defines the level of risk of a temporary loss. The token is combined with another token, typically a stablecoin like Tether (USDT) and an Ethereum-based token like Ether (ETH). Pools with assets like stablecoins within a tight price range are less prone to temporary losses. As a result, liquidity providers face less risk of temporary loss in this scenario with stablecoins.)

This is because trading fees can offset the temporary loss. For example, pools on Uniswap, which are highly prone to temporary losses, can be profitable due to trading fees (0.3%).

How does impermanent loss happen?

The difference between the value of the LP tokens and the theoretical value of the underlying tokens when not matched results in IL. Let’s look at a hypothetical situation to see how impermanent/transient loss occurs. Suppose a liquidity provider with 10 ETH wants to offer liquidity to a pool of 50/50 ETH/USDT. You need to deposit 10 ETH and 10,000 USDT in this scenario (assuming 1 ETH = 1,000 USDT). If the pool you are committing to has a total asset value of 100,000 USDT (50 ETH and 50,000 USDT), your share equals 20% using this simple equation = (20,000 USDT/ 100,000 USDT) * 100 = 20 %

The percentage of a liquidity provider’s participation in a pool is also significant because when a liquidity provider commits or deposits its assets into a pool via a smart contract, it immediately receives the tokens from the liquidity pool. Liquidity providers can withdraw their share of the pool (20% in this case) at any time using these tokens. So can you lose money with a temporary loss? This is where the idea of ​​IL comes into play. Liquidity providers are vulnerable to another layer of risk known as IL as they are entitled to a portion of the pool rather than a defined number of tokens.

As a result, it occurs when the value of your deposited assets changes from the time you deposited them. Note that the higher the change, the more IL the liquidity provider is exposed to. Loss here refers to the fact that the dollar value of the withdrawal is lower than the dollar value of the deposit. This loss is not permanent as there is no loss if the cryptocurrencies are allowed to return to price (i.e. the same price as when they were deposited in the AMM). Also, liquidity providers receive 100% of trading fees offsetting the risk of temporary losses.

How to avoid impermanent loss?

Liquidity providers cannot completely avoid temporary losses. However, you can take some measures to mitigate this risk, such as: B. A strategy to avoid temporary losses is to choose stablecoin pairs that offer the best bet against IL as their value doesn’t move much; They also have fewer arbitrage opportunities, which reduces risks. Liquidity providers using stablecoin pairs, on the other hand, cannot benefit from the
cryptocurrency bull market. Choose pairs that do not expose liquidity to market instability and temporary losses, rather than cryptocurrencies with a shaky track record or high volatility.

Another strategy to avoid temporary losses is to thoroughly scan the market, which is very volatile. As a result, the deposited assets are expected to fluctuate in value. Liquidity providers, on the other hand, need to know when to sell their holdings before the price deviates too far from initial prices. As a result, large financial institutions are not participating in liquidity pools due to the risk of temporary DeFi loss. World, this problem can be solved.

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