What Is Impermanent Loss?
When there is a price difference between the two assets a trader owns on a DEX, often a cryptocurrency and a stablecoin (such as USDC), impermanent loss might occur. The trader may incur a loss as a result of the price differential when the value of the cryptocurrency declines in relation to the stablecoin. Impermanent loss is what is meant by this.
What Causes Impermanent Loss?
When traders utilize a DEX to purchase one asset with another asset, they suffer an impermanent loss. A trader is vulnerable to the price changes of both assets, for instance, if they purchase Ethereum using USDC. The trader will experience a smaller profit or even a loss if the price of ETH declines in relation to USDC. This is due to the fact that in order to return to the initial USDC value, they must sell the ETH at a lower price.
Let's say a supplier needs to supply the same amount of liquidity in USDC and ETH, but all of a sudden, the price of ETH increases. Due to the fact that the price of ETH in the liquidity pool no longer reflects the market price, arbitrage opportunities are now present. While the equilibrium is out of balance, other traders will purchase ETH at a discount.
After arbitrage, a liquidity provider might have more UDSC and a little less ETH in their possession. The difference between a trader's new portfolio balance and what they would have had if they had simply hung onto their previous balance is known as an impairment loss. When a trader removes liquidity from the pool, the loss is realized.
How Can Impermanent Loss Be Avoided?
Using stablecoins like USDC and DAI or wrapped copies of the same assets like Curve's wBTC can help prevent temporary loss. In addition to the 50/50 paradigm, Balancer also provides variable weights for its liquidity pools, which can lower the chance of temporary loss if a token has a bigger weight in the pool.
A few DeFi protocols are also starting to investigate novel solutions, such as the price oracles Bancor uses and the single-sided liquidity pools Tokemak uses, where the protocol's native token assumes the risk of temporary loss in exchange for swap fees and bribe incentives.
Create a portfolio of assets that are moderately well-correlated to reduce impermanent loss. In this manner, the portfolio will continue to be largely balanced when the prices of the assets diverge, and the trader may steer clear of any unforeseen losses.