Five strategies to help you avoid impermanent loss in DeFi

This article is sourced from Bankless, authored by William M. Peaster, and translated by Unitimes Unicorn Era.

Impermanent loss, also known as "non-permanent loss," refers to the loss of value due to providing liquidity to automated market makers (AMMs), which is an inherent risk of providing liquidity in DeFi. Understanding how to navigate this phenomenon can help liquidity providers (LPs) better supply liquidity to AMMs. This article will outline some different strategies to help you reduce or avoid impermanent loss during DeFi activities.

What is Impermanent Loss?

Decentralized exchanges (DEXs) in the DeFi ecosystem pioneered the automated market maker (AMM) model. AMMs are centered around liquidity pools, which are driven by liquidity providers (LPs) who deposit crypto assets into these pools for anyone (traders) to trade through these liquidity pools.

What is the main idea behind this? Traders can exchange the tokens they want at any time through the liquidity pool, and LPs earn a portion of the trading fees when the tokens in the liquidity pool are used.

However, for many liquidity pools, whether their LPs can profit from trading fees over a specific period is far from guaranteed. This is due to the so-called impermanent loss: the fundamental risk of providing assets to a liquidity pool due to the inherent nature of how AMMs work and the volatility of cryptocurrencies.

In simple terms, AMMs like Uniswap use special algorithms to automatically maintain a balanced ratio of assets in a liquidity pool, such as keeping the value of ETH/WBTC in a 50/50 ratio, while price fluctuations of ETH and WBTC lead to rebalancing. In this case, LPs will incur a loss of funds compared to their initial deposit.

Concept of liquidity pools, image source: Finematics

This loss is also referred to as "non-permanent" loss because it only becomes permanent when LPs withdraw their liquidity while experiencing impermanent loss. For example, due to market fluctuations, your LP position in a liquidity pool may incur impermanent loss today, but this loss may disappear tomorrow, and so on.

What is the simplest way to understand impermanent loss?

Impermanent loss occurs when the value of an LP position is lower than the value of those deposited tokens on the open market. In other words, if you would have made more profit simply holding ETH and WBTC in your wallet rather than providing liquidity to the ETH/WBTC pool on Uniswap, then impermanent loss has occurred.

An Example of Impermanent Loss

If you still cannot grasp impermanent loss, here is a simple example to help you understand.

Suppose you go to Uniswap and want to provide $1,000 of liquidity in the ETH/USDC pool. If the current price of ETH is $1,850 and USDC is $1, and since you need to invest $500 in each of these two assets, this means you will ultimately deposit approximately 0.27 ETH and about 500 USDC into the pool.

Now let’s assume that a few weeks later, the price of ETH drops to $1,400. At this point, your LP position will rebalance to 0.31 ETH and 434.96 USDC, with a total value of $869.92.

In comparison, if you had simply held the initial 0.27 ETH and 500 USDC (instead of providing liquidity on Uniswap), the total value of these two assets would be $878.38, which is over $8.50 more than $869.92. In this hypothetical example, the LP experienced an impermanent loss of less than 1% ($8.50 / $1,000 = 0.85%).

If you are interested in calculating impermanent loss, you might consider using the dailydef.org impermanent loss calculator tool centered around Uniswap.

Impermanent loss calculator

Strategies to Mitigate Impermanent Loss

Now that we know what impermanent loss is, how can we combat it? In many liquidity pools, impermanent loss is an unavoidable reality, but there are certainly a range of strategies that can be used to lessen or even completely avoid the impact of impermanent loss.

Here are some of the most basic strategies to mitigate impermanent loss.

Avoid High Volatility Liquidity Pools

Cryptocurrency assets like ETH are not pegged to the value of external assets like stablecoins, so their value fluctuates with market demand.

It is important to note that liquidity pools centered around volatile assets are the greatest source of impermanent loss risk. While blue-chip cryptocurrencies like ETH and WBTC may be volatile, other smaller coins face a greater likelihood of intraday price fluctuations, making them riskier from the perspective of impermanent loss.

If avoiding impermanent loss is the most important aspect for you, a wise choice would be to avoid providing liquidity to high-volatility liquidity pools.

Choose Liquidity Pools Anchored to the Same Asset

Stablecoins like USDC and DAI are pegged to the value of the dollar, so these stablecoins always trade around $1. There are also other crypto assets anchored to the same asset, such as sETH and stETH pegged to ETH, and WBTC and renBTC pegged to BTC.

In liquidity pools anchored to the same asset (like the USDC/DAI pool), the volatility between these tokens is minimal. This dynamic naturally results in very little or no impermanent loss for LPs. Therefore, if you want to be an LP and earn fees without facing significant impermanent loss, choosing to provide liquidity to these pools anchored to the same asset is a good option.

Provide Liquidity to Staking Pools

In DeFi, not all LP opportunities come from dual-token liquidity pools. In fact, another popular source of income for LPs is staking pools, which are typically used to ensure the solvency of DeFi protocols (in case of insolvency) and only accept deposits of one type of asset.

For example, the staking pool Stability Pool of the lending protocol Liquidity: users provide LUSD stablecoins to the Stability Pool to ensure the solvency of the Liquidity protocol, and in exchange, these LPs will earn a share of the accumulated liquidation fees from the Liquidity protocol. There is no impermanent loss in such staking pools because there is no rebalancing of ratios between two assets!

Choose Liquidity Pools with Uneven Asset Ratios

Liquidity pools with uneven asset ratios refer to pools where the value ratio of assets is not traditionally split 50/50. Balancer is known for pioneering such flexible liquidity pools, where the asset ratios in liquidity pools can be 95/5, 80/20, 60/40, and so on.

These asset ratios will impact impermanent loss. For example, in the case of an 80/20 AAVE/ETH pool, if the price of AAVE rises relative to ETH, the impermanent loss impact due to price fluctuations will be less for LPs since the majority of their risk exposure is AAVE (which makes up 80% of the pool) compared to providing liquidity to an AAVE/ETH pool in a 50/50 ratio.

Thus, providing liquidity to such uneven asset ratio liquidity pools is also a way to mitigate impermanent loss, although this still entirely depends on the price performance of the underlying assets.

Participate in Liquidity Mining Programs

Today, liquidity mining programs (where protocols distribute governance tokens to initial LPs) are ubiquitous in DeFi. Why? Because liquidity mining provides these DeFi protocols with a simple way to achieve decentralized governance, attract liquidity, and win over early users.

However, there is another advantage to participating in liquidity mining: in many cases, the token rewards earned from participating in liquidity mining can offset any impermanent loss faced by LPs. In fact, if the token rewards you earn from participating in liquidity mining over two months amount to 25%-100% of the value of your initial liquidity deposit, then experiencing a 5% impermanent loss during that time is negligible.

At the very least, these token rewards can offset the impermanent loss encountered by LPs, so as an LP, you should always keep in mind those liquidity pools that offer incentives.

Conclusion

As AMMs become increasingly popular, impermanent loss is a phenomenon that more and more people will have to contend with. The good news is that there are some viable strategies to help you navigate this with capability and caution.

Looking ahead, the recent launch of Uniswap V3 introduced "concentrated liquidity," which allows LPs to provide liquidity within specific price ranges rather than having to accept providing liquidity across the entire price range (zero to positive infinity) as before, placing this approach at the forefront of DeFi.

"Concentrated liquidity" amplifies LPs' earnings and impermanent loss, making it a new and more efficient LP model. As this concentrated liquidity model continues to be further adopted, we can expect to see more discussions around managing impermanent loss!

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