The risks of a liquidity pool: impermanent loss.
8 april 2022 by Catherine Woods
Reading time 5 min
Impermanent loss takes a special place in the ranking of the most essential metrics relating to pools. This concept has an unclear name, and it's hard to argue with that. But one of the hidden risks for a liquidity provider, impermanent loss, is a topic that should be well understood.
Let's imagine the situation where an investor forms a pool with digital assets on a DEX and becomes a liquidity provider. On the market, the price of tokens begins to fluctuate depending on market supply and demand. There is a risk of impermanent loss of DeFi assets for the liquidity provider. By the way, other investors will see a chance to get income on arbitrage. At this time, Automated Market Maker or AMM, like an order book on a centralized exchange, will define the ratio of digital assets in the pool. In these conditions, prices of digital assets from the pool can move sharply until they reach equilibrium. And this is an invisible risk for providers. The liquidity of the pool is constant, the ratio of funds changes.
Large price changes bring liquidity providers, concisely LP, impermanent loss on a huge scale. Impermanent loss turns permanent once LP moves out funds of the pool when the price of deposited tokens changes. The number of assets that the LP can withdraw is a share of the pool. It is necessary to understand about impermanent loss, crypto sectors of the economy, especially DeFi ecosystem, are too unstable.
But what happens if an ordinary investor and trader keeps his own tokens in his wallets but doesn't provide liquidity? In this case, one can gain income, due to changes in the market and price appreciation of the assets kept.
Simply put, an investor can hold his funds in a wallet or provide liquidity to other traders by locking them into a smart contract of the pool. Thus, two courses of investor behavior are discovered. And against this background, if the rewards and fees are smaller compared to the losses for the provider due to assets price change, then it is more profitable to take the course on the HODL.
Besides, the direction of price change does not matter for this loss. It means: impermanent loss comes from increasing and decreasing the prices of tokens. Under the concept of impermanent losses, the percentage change of token prices and the time that they are deposited into the pool makes sense. In addition, investors can find impermanent loss calculator that does the math.
In the context of DeFi crypto, impermanent loss can be minimized or escaped. A pool can consist of the digital asset that will be less susceptible to impermanent loss, stablecoin, for example, that stays in a narrow price range. So liquidity providers can mitigate this risk by moving away from the volatility of digital assets. So by choosing pools with pairs of stablecoin, impermanent loss can be reduced to a minimum.
Every liquidity provider is exposed to these potential lost digital assets. And anyway, he provides liquidity in the pool because he has the ability to earn income from a trading fee. The latest can make each pool profitable. Moreover, providers can get platforms tokens as rewards.
Consequently, investors can gain profit by providing liquidity, receiving insurance against impermanent loss, farming or staking. But in order to make money, investors must keep in mind the risks of the liquidity pools from DeFi: impermanent loss, smart contract risk, developer access threat, slippage risk.