Impermanent loss (IL) is the situation whereby the prices of tokens change compared to when they were deposited in a liquidity pool by providers. The risk increases with the size of the change.
Liquidity provision is beneficial to a pool, however, it’s good to know how to avoid an impermanent loss. Anyone who joined DeFi via staking knows the immediate risk of a liquidity pool.
The Pros of Providing Liquidity
The main benefit of liquidity pools is the ability to make exchanges. There is no need to look for a partner who assigns the same cryptocurrency value as you.
Anyone who trades crypto knows that you need top-notch bargaining skills when dealing with someone who is selling their crypto at a high price. In a liquidity pool, you can exchange even when you lack these skills.
Moreover, liquidity pools have a low market impact since transactions tend to be smoother. The pool is locked in a smart contract where prices change based on an algorithm.
Lastly, you receive rewards for providing liquidity since you are staking tokens and renouncing your ability to sell them.
The Cons of Providing Liquidity
The biggest disadvantage of providing liquidity is impermanent loss. Your assets lose value when you make them liquid.
Due to the absence of a third party in DeFi, your sole custodian is the smart contract, If it catches a bug, you risk losing all your funds.
For this reason, providers should try and deposit their funds in pools that are less likely to suffer from impermanent losses.
How To Avoid Impermanent Loss
In real honesty, impermanent loss is inevitable since the prices will most definitely fluctuate. However, there are some methods you can use to mitigate the risk including;
1. Use of Stablecoin Pairs
When providing liquidity, make two stablecoins liquid, For instance, if you provide liquidity to USDT and USDC, there will be no risk of impermanent loss since the stablecoin prices are meant to be stable.
The downside is that you won't benefit from any rise in the market. If you’re liquidity mining in a bull market, holding stablecoins is useless since you won’t get any returns on them.
However, if you’re mining in a bear market, try to provide liquidity to stablecoins and earn trading fees. This way, you will profit from the fees without making any losses.
2. Keep an Eye on the Trading Fees
Traders in a pool are required to pay trading fees. An automated market maker (AMM) gives a share of these fees to liquidity providers.
Sometimes, the fees are enough to cancel out the impermanent loss which decreases as the trading fees collected increase.
3. Pick Low Volatility Pairs
Some cryptocurrency pairs are more volatile than others therefore, providing liquidity to them can increase the risk of impermanent loss.
However, if you think both currencies will rise or fall relative to each other in terms of price, then it won’t make much of a difference.
4. Choose a Flexible Liquidity Pool Ratio
Most AMMs have a 50:50 ratio that increases the chances of impermanent loss. This is because they want to create a balance liquidity pool.
However, some decentralized exchanges provide liquidity in different rations and allow you to pool more than two cryptocurrencies. When the ratio is high, it doesn’t cause as much loss as the 50:50 one.
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