The crypto market is both unpredictable and volatile, and there are lots of ways that you can lose money. Fund loss in the crypto industry can come as a result of a number of factors, such as a bad investment, selling your assets at the wrong time, or impermanent loss.
But what is impermanent loss, and is it one of crypto’s riskiest elements?
What Is Impermanent Loss?
A particularly integral part of the crypto market is liquidity pools. Liquidity pools involve users on an exchange or similar platform pooling their assets in one place so that the platform can achieve a goal.
For example, the Ethereum blockchain uses staking pools in its block validation process through something called staking. Because an individual needs at least 32 ETH to be an independent validator on the blockchain, many choose to pool their funds in staking pools instead. Staking pools can have thousands of users in them and are hugely popular among crypto users. However, they don’t come without their risks.
In the staking process, a user often has to lock away a portion of their funds for the duration of the staking period. But because cryptocurrency prices fluctuate all the time, it’s almost certain that the coin price at the end of the staking period will differ from its value beforehand. While these price differences are usually minimal, big waves of change within the market can lead to significant drops or hikes in a coin’s value.
If price changes lead to volatility in a trading pair while someone is staking their funds, it can lead to impermanent loss. As the price difference between the trading pair grows, your exposure to impermanent loss grows with it. When an impermanent loss occurs, the value of the deposited crypto exceeds that which is available to you after its time in a liquidity pool.
Impermanent loss is also common in trading pairs with one stablecoin. Because stablecoins are less subject to drastic changes in value (as they are pegged to traditional currencies and reserves), it’s easy for the other crypto in the pair to experience a price fluctuation due to a market trend, while the stablecoin remains just that, stable. But this kind of fund loss can occur regardless of whether a stablecoin is present in the pair.
Let’s look at an example of impermanent loss so that we can understand it more easily.
A Quick Example
Let’s say a crypto user named Mark decides to deposit 80 Algorand (ALGO) and 2 Cosmos (ATOM) into a liquidity pool. At the time of deposit, one ATOM is worth 40 ALGO. Let’s say there’s a total of 800 ALGO and 20 ATOM in the pool, and Mark has a 10% share.
Then, while Mark’s funds are in the pool, the price of ATOM shoots up, so that one ATOM is now worth 80 ALGO. This means that a significant price difference between the two tokens within the trading pair now exists, and so the ratio between the two assets has also changed. Because of this, arbitrage traders will now add more ALGO to the pool while taking away some ATOM.
On top of this, there is now 1,600 ALGO and 10 ATOM in the pool. At this point, Mark decides that he wants to withdraw his funds from the staking pool as he is under the impression that he is losing money with the lower amounts of ATOM in the pool.
With his 10% share, Mark is entitled to withdraw 160 ALGO and 1 ATOM. Because the ratio of his withdrawn funds is different from when they were deposited, his returns are now in the negative.
Can You Reverse Impermanent Loss?
Because liquidity providers in a pool make money from the trading fees charged for every trade made using the pool, the profits made in this way can, sometimes, make up for the loss. But this is certainly not always the case and depends on the degree of loss incurred by the price change within the trading pair.
But what makes impermanent loss impermanent? Well, if a user decides to keep their funds in a liquidity pool after a price shift has caused a loss of funds, and they happen to bounce back due to another price shift, the loss is only temporary. The loss only becomes permanent when the user decides to withdraw their funds after the initial price shift, just like Mark did in the example above.
Impermanent loss currently affects a very large proportion of individuals who use liquidity pools, though many remain to be unaware of it. This is because, sometimes, the value of a user’s funds in a pool may even increase, but it still doesn’t make them as much of a profit compared to buying and holding the tokens (also known as HODLing). Pool fees can be pretty hefty, so these can quickly eat into a user’s profits within a pool.
Avoiding Impermanent Loss
The risk of impermanent loss is present in the majority of liquidity pools. However, the chance of impermanent loss occurring increases if one or both of the tokens in a trading pair are volatile in terms of price. So, you should always do a little research around the tokens within a trading pair before entering a liquidity pool, as you may notice that their prices are extremely volatile.
It also pays to be aware of the automated market maker, or AMM, that you use in a liquidity pool. AMMs are a type of decentralized exchange protocol that incentivize users to become liquidity providers within a pool. Order books within exchanges are often replaced by AMMs, giving way to a trustless process in which trading pairs can be priced accurately.
AMMs are also used to ensure that the ratio of the two assets in a pair remains as balanced as possible within a pool in the event that price changes occur. They act as the backbone of such pools but can also become problematic if messed with.
Some individuals alter AMMs, giving them bugs that can lock your funds into a pool indefinitely. So, it’s important to use established, reliable AMMs whenever you want to become a liquidity provider. You should be especially cautious if a pool is offering returns that seem too good to be true, as there is likely some sort of monetary catch here that could leave you worse off than you were initially. In short, the more poorly designed the AMM is, the more you are exposed to impermanent loss.
Be Aware of Impermanent Loss When Using Your Crypto
Impermanent loss has already affected the crypto holdings of thousands, or even millions, of individuals, and it will continue to do so as long as liquidity pools continue to exist within the market. So, if you use liquidity pools, or you’re thinking about doing so, be sure to check the volatility of your chosen trading pair before committing to anything, as this could save you from a considerable fund loss.
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