The Problem of Impermanent Loss In DeFi: Possible Solutions
As a decentralized finance or yield farming enthusiast, you must have heard about the impermanent loss in DeFi. Many analysts have opined that DeFi is the future of finance and can relegate the traditional finance system to the background. However, DeFi also has its own drawback.
People can lose their money by providing liquidity on decentralized exchanges like PancakeSwap, Uniswap, SushiSwap, etc. Quite a few people understand the concept of impermanent loss in yield farming. What is it, and what are the possible solutions to it in today’s space? We are going to looking into all these and more in the article. However, before we delve into that, let’s have a quick introduction to decentralized finance protocols.
Also read: 101 of DeFi Yielding: A comprehensive guide for beginners
In recent times, decentralized finance protocols like ApeSwap, Uniswap, PancakeSwap, etc., have all experienced increased volume and liquidity. Anyone can stake their digital assets in order to provide liquidity in these protocols. They become a market maker in the process and earn trading fees for their services.
The introduction of automated money makers (AMM) in the crypto industry has created frictionless economic activities. Now, these market makers are being threatened by this impermanent loss inherent in DeFi protocols.
What Is Impermanent Loss in DeFi?
Impermanent loss in DeFi occurs when a liquidity provider or market maker provides liquidity to a liquidity pool, and the price of the deposited assets becomes different from when he/she deposited the assets. The size of the change is directly proportional to the degree of exposure to impermanent loss in yield farming. Therefore, if the change in price is big, you will be more prone to experience impermanent loss. The loss here means you will have less amount of money during withdrawal than when you made the deposit.
It is the temporary loss of money due to the volatility of trading pairs in a liquidity pool. It goes to show how much money a liquidity provider would have had if he/she held unto their assets instead of being a market maker on a liquidity protocol like PancakeSwap. The trading pairs in a DeFi liquidity pool often have two assets; a stablecoin like USDT and another more volatile asset like DOT.
How Does Impermanent Loss in Yield Farming work?
Let’s take a look at how a liquidity provider or market maker can experience an impermanent loss. If Chris is a liquidity provider and deposits 1 DOT and 100 USDT in a liquidity pool, the token pair must be of the same/equivalent value. It means that the price of 1 DOT at the time of deposit is 100 USDT. This also means that the total dollar value of Chris’ deposits is 200 USDT.
Additionally, there is a total of 10 DOT and 1,000 USDT in the pool, all funded by market makers like Chris. So, the total liquidity is 10,000, and Chris has a 10% share of the pool. Let’s assume that the price of DOT increases to 400 USDT. As that is happening within the pool, arbitrage traders will continue to add USDT to the pool while at the same time removing DOT until the ratio matches the current price in the market.
Since automated market makers do not have order books, the pool’s price is determined by the ratio between the assets in the pool. Although the liquidity in the pool remains constant (10,000), the ratio of the assets in the pool changes. There will be 5 DOT and 2000 USDT in the pool, all thanks to those arbitrage traders. Bear in mind that Chris is entitled to 10% of the liquidity pool. Therefore, he can withdraw 0.5 DOT and 200 USDT, totaling 400 USDT. You can see that Chris made a good profit.
What would have been the case if Chris has held unto his 1 ETH and 100 USDT? He would have had 500 USD if he held onto his assets and not staking them in the liquidity pool. This 100 USD loss by Chris is known as impermanent loss in DeFi.
Are there ways that DeFi protocols can protect market makers who engage in yield farming? What possible solutions can we leverage to mitigate the impact of impermanent loss in DeFi? Here are the few ways liquidity providers can shield themselves in this situation:
Market makers should provide liquidity to stablecoin pairs in the pool.
Providing liquidity to liquidity pools that are made up of two stablecoins like DAI-USDT is arguably the best way to protect you against impermanent loss in yield farming. The downside of this is that you are likely not going to enjoy the rise in the market as they have little effect on stabelcoins. Providing liquidity in a bear market will allow you to earn trading fees without the risk of losing your asset.
Also related: The rise of decentralized finance: Why banks need to pay attention
Take part in liquidity mining programs and provide liquidity to pools with incentives.
The exponential growth of the decentralized finance market has given rise to lots of DeFi apps and DEX. Most of these platforms issue their own native tokens. These native tokens are distributed to liquidity providers through the platform’s liquidity mining programs. To mitigate impermanent loss, you can engage in liquidity mining in order to provide liquidity to incentivized pools.
Wait for the exchange rate to return to the initial rate.
At the time you staked your digital asset in a pool, there was a market rate. The truth is that the market rate at which you provided liquidity will change with time. It is normal, and it happens regularly. However, the impermanent loss will be more pronounced when the market rate changes notably from the initial rate. At this point, you should wait for the market to return to the original rate; then, you can exit the pool with no impermanent loss.
Irrespective of the price shift, impermanent loss in DeFi always occurs. Therefore, leveraging any of the highlighted solutions is your best approach as a liquidity provider. You can also share your views in the comment section below.