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Impermanent Loss: Everything You Need to Know

by Grizzly Aug 27 2021

Blockchain technology can be very profitable, especially when we consider DeFi (decentralized finance) solutions like liquidity mining. Although liquidity mining is a great way of gaining a steady source of blockchain-based income, many people are concerned with liquidity mining risks such as impermanent loss. But what is impermanent loss really, and most importantly – what can you do to protect yourself from it?

 

What Is Impermanent Loss? 

Impermanent loss is one of the most common liquidity mining risks, and happens when the price of the two tokens in a liquidity mining pair starts to diverge too much from their original values due to market volatility. When the value of one asset in the pair changes in relation to the other, the distribution of value between the two tokens changes to the provider’s disadvantage.

Let’s say that a liquidity pool includes two tokens: token A and token B. If token A increases in value but token B does not, people will start withdrawing token A and depositing token B. Because of that, you will end up owning less of the better performing token and having more of the worse performing token.

When impermanent loss happens, liquidity providers find themselves suddenly having a lot more of the less profitable token in their wallet compared to when they started liquidity mining. In other words, impermanent loss means that simply holding two assets separately would have outperformed the gains made with liquidity mining.

For some people, liquidity mining risks like impermanent loss are one of the reasons why they decide to not mine liquidity at all. However, blockchain investors who understand what is impermanent loss and why it happens can greatly mitigate the risk, and keep liquidity mining profitable even in the highly volatile crypto ecosystem.

 

Impermanent Loss: Why Does It Happen?

Although technical details involved in impermanent loss can seem quite complicated at first, the main reason why impermanent loss happens is simple: the crypto market is notoriously volatile, and the prices of cryptocurrencies change all the time. 

The price of any digital currency can massively increase or fall down within hours, and sometimes even minutes. The volatility of cryptocurrency is much higher compared to traditional assets such as stocks or precious metals, and is a feature of the blockchain ecosystem which needs to be accepted and properly addressed by any blockchain investor who wants to maximally increase their liquidity mining gains. 

In other words, there is no way to fully stop impermanent loss from happening – in fact, it is the most common liquidity mining risk which all liquidity providers have to take into consideration. Simply put, drastic changes of the prices of assets in a liquidity pool can always result in massive lowering of the liquidity mining profitability.

When impermanent loss happens, withdrawing your funds from the pool would prevent you from gaining profit from liquidity mining. However, most liquidity mining platforms automatically balance liquidity mining profits, which means that the liquidity pool will most likely become profitable again as the time passes – that’s why the loss is considered impermanent.

 

Does Impermanent Loss Make Liquidity Mining Risky?

When people hear about liquidity mining risks like impermanent loss, they decide that liquidity mining is risky and not worth the effort. However, this point of view is caused by a misconception in understanding what is impermanent loss and how it can be mitigated.

For one, liquidity mining is considered an extremely safe way of profiting from blockchain technology compared to other methods of gaining exposure to digital markets such as trading crypto. While impermanent loss can make your investment less profitable in the short term, liquidity mining doesn’t involve the danger of actually losing all your funds.

It’s also worth noting that the risk of impermanent loss is simply the result of natural volatility of the crypto market. In other words, it’s not something specific to liquidity mining – even if you simply held your assets in a wallet, you could still take a loss in profit caused by the volatility, but you wouldn’t be able to enjoy the opportunity of earning liquidity mining gains.

 Finally, while impermanent loss can never be fully avoided, it can be easily mitigated to a degree that it can effectively stop being a concern for liquidity providers.

 

How to Protect Yourself From Impermanent Loss? 

Preventing impermanent loss isn’t hard, and all it requires is doing some research before locking your assets in a liquidity pool. The most common ways of mitigating impermanent loss include stablecoin pairs, avoiding volatile assets and calculating the impermanent loss risk before you start liquidity mining.

Stablecoin Pairs

Stablecoins were specifically designed to protect cryptocurrency investors from high volatility. Since the prices of stabe digital currencies are pegged at a 1:1 ratio to traditional fiat currencies like the US Dollar, their prices are not as volatile as the prices of other crypto assets.

Decentralized stablecoins use automated algorithms to retain the peg to the dollar, which means that small, temporary changes in price can still happen. However, they are much smaller than with other cryptocurrencies, so the resulting loss in profitability of liquidity mining is minimal.

Avoiding Volatile Assets

The cryptocurrency market as a whole is highly volatile, but it doesn’t mean that all digital assets are equally susceptible to price changes. Many different factors can impact the volatility of particular cryptocurrencies – for example, some less decentralized assets can be more prone to market manipulation, and the constant pumps and dumps make them very bad assets to use in liquidity mining.

Fortunately, avoiding volatile assets is very simple. A quick glance at the historical chart of any crypto will let you quickly decide if an asset is highly volatile or not.

 

Conclusion 

As we can see, impermanent loss is not as scary as some people think. While it can decrease the profitability of liquidity mining in the short term, it doesn’t change the fact that liquidity mining is still a very secure form of gaining crypto passive income. By taking few simple precautions such as mining liquidity with stablecoin pairs and avoiding volatile assets, the risk of impermanent loss can be mitigated to minimum.

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