The smart contract converts your entire liquidity position to the least valuable asset in the pair. Impermanent loss is known as a silent killer in the industry, since it is difficult for users to notice it. The value of a user’s holdings in a liquidity pool may rise if the composite tokens increase in price, creating the illusion of profits. However, compared with simply buying and holding the staked assets in the contributed amounts, the user may still be incurring losses. A recent study on impermanent loss conducted by crypto consultancy Topaze Blue found that around 50% of users staking their tokens in Uniswap V3 are suffering negative returns. In certain pools, the percentage of users who lost more from IL than they gained in trading fees was as high as 70-75%.
But a review of the basics can provide the tools necessary for such a report. Learn more about DeFi and stay up-to-date with the latest developments for Ruby.Exchange https://www.xcritical.com/blog/what-is-liquidity-mining/ by subscribing to the blog, or following us on Twitter and Telegram. The other more common case of V3 IL is when the price moves but stays within the range.
Liquidity Pools and Automated Market Makers
Stablecoins or different wrapped versions of a coin, for example, will stay in a relatively contained price range. In this case, there’s a smaller risk of impermanent loss for liquidity providers (LPs). Well, it comes from an inherent design characteristic of a special kind of market called an automated market maker. Providing liquidity to a liquidity pool can be a profitable venture, but you’ll need to keep the concept of impermanent loss in mind.
In this guide, we will explain exactly what impermanent loss is, provide an easy to follow example and outline the steps investors can implement to mitigate the risk. The advent of decentralized finance (DeFi) has opened up a world of possibilities for cryptocurrency investors to earn interest on their holdings. Let’s assume an LP provides liquidity to a DAI/ETH Uniswap 50/50 pool. To supply liquidity to a 50/50 pool, the LP has to provide an equal value of both tokens to the pool. On the other hand, when you buy crypto on the Automated Market Makers, there is no seller.
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LPs should already be familiar with the concept of IL from QuickSwap’s V2. Simply put, it refers to the loss you may suffer from providing liquidity instead of simply holding the two assets in your wallet. Here’s a more detailed explanation of how IL works on QuickSwap’s V2. Bancor released a solution in late 2020 that fully protects users from impermanent loss by insuring against the risk at the protocol level. Now, one year later and with over $200 million earned by Bancor depositors in the last 10 months, the project is gearing up for the release of its third protocol version. Like its predecessor, Bancor V3 will fully protect users from a risk that threatens to undermine the core tenets of DeFi.
- Self-evidently, these pools offer identical exposure to both assets since price changes in either will affect the pool in the same way.
- If you were to take 1 BTC for 5 ETH, the total supply would be 99 BTC and 505 ETH.
- Get degen trade ideas, governance updates, token performance, can’t-miss tweets and more from Blockworks Research’s Daily Debrief.
- It is imperative to understand that you can witness impermanent loss irrespective of the price movements.
- Naturally, the easiest way to reduce the risk of impermanent loss is by choosing less volatile pairs.
- There will be no more losses when prices are back exactly where they were when you entered the pool.
Another example is Balancer that offers pools with arbitrary weights outside of the standard 50/50 weighted model. This can also reduce the impact of impermanent loss depending on the weights in the pool. The higher the weight of a token in the pool, the lesser the difference between holding the token and providing liquidity in the token becomes. These could be different stable coins like USDC and DAI or different flavours of the same token such as sBTC, renBTC and wBTC. The risk of impermanent loss in such pools is greatly minimised as there is no asset in the pool whose value is volatile in relation to the other. This is also why Curve’s liquidity pools, or to be more generic, all the liquidity pools that hold stable assets usually attract way more capital than the pool with non-stable assets.
Impermanent Loss in Standard Pools
The number of liquidity providers and tokens in the liquidity pool determines the level of impermanent loss risk. For example, many IL calculations do not account for the mints and burns that a liquidity provider https://www.xcritical.com/ may make in a single day. Minting refers to the LP tokens that are created when funds are deposited. Liquidity providers will often try to time minting and burning to avoid volatile price swings in a pool.
If the price of crypto has been fluctuating for some time— it can become a risky crypto pair, with a more likely chance of leading to impermanent loss. Similarly, cryptocurrencies with significant price differences can also result in an impermanent loss compared to similarly priced ones. Simply, liquidity pools are a kind of smart contract-locked system of funds that allows lending and trading in the DeFi markets. Impermanent loss is bound to occur in all liquidity provision scenarios.
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By taking advantage of this, arbitrage traders end up naturally rebalancing in the pool. This is an important part of how AMMs stay operational, but creates a problem for liquidity providers. By decentralising traditional financial services, anyone can now lend funds to DeFi applications. Depositing digital assets, often into standard liquidity pools, can earn investors interest rates far above what is currently offered by global banks.
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In this article, I will explain what is Uniswap impermanent Loss, and why this is such a hot topic for liquidity providers
So, what do you need to know if you want to provide liquidity for these platforms? In this article, we’ll discuss one of the most important concepts – impermanent loss. To understand how impermanent loss occurs, we first need to understand how AMM pricing works and the role arbitrageurs play. After developing a keen interest in traditional financial investing, James transitioned across to the cryptocurrency markets in 2018.
