Impermanent Loss is a pretty common word in the Defi arena. Few people will learn it before investing, others will learn it, the hard way by losing enough.
What is Impermanent Loss?
Impermanent loss is the loss incurred due to the change in the currency pair’s price after providing the liquidity. Bigger the change, the bigger the loss.
With the immense explosion of Defi platforms like Pancakeswap, Uniswap, 1inch, Burgerswap, etc., liquidy protocols allow anyone to provide liquidity by providing the currencies required for the trading pairs thereby earning a trading fee for all the transactions happening on the particular exchange which involves said currency pairs.
Let us understand this with an example :
User A wants to provide liquidity to a pool say BNB – SWGB Pool.
- The user will create a pool by submitting a 50:50 ratio. i.e, the worth of the tokens should match not the quantity. Meaning, if 1BNB=1000SWGB as per the current market rate at the time of creating the pair. User, A needs to submit 1BNB and 1000 SWGB for Liquidity Pool.
- Once LP is created, the user will be earning a trading fee on all the trades happening on the particular exchange in the submitted LP.
- Assuming post creation of pair, price of cake has been changed exponentially say 1BNB = 750 SWGB, and if a user wants to remove liquidity, he/she will no longer get 1BNB and 1000SWGB, instead, the user will get 750SWGB and 1.25BNB.
- The higher the change in the price of one token, the higher would be an impermanent loss.
How to play Smart with Impermanent Losses :
While impermanent losses are inevitable while providing liquidity to a pool, here are few points that can be kept in mind :
- If you see in the above example, both of the token in LP are cryptocurrencies, hence there would be huge fluctuation of prices of those token creating a risk of higher Impermanent loss
- It is suggested to create an LP, with at least one Stable currency like BNB-BUSD, BNB-USDT, etc., as per the applicability.
- Since BUSD, USDT, etc., are stable currencies, these are tethered to real-world USD and their price will be stable. leaving to worry about one side of the pair.
- If one of the crypto involved in the pair becomes zero, then the whole LP pair will result in zero returns on Withdrawal.
- To minimize Impermanent losses, submit these LP pair tokens to Farms offered in different platforms like Pancakswap. finance, pancakebunny.finance, burgerswap, etc., and earn their native tokens like $Cake, $bunny, etc.,
- If the price of both the tokens in the pair increases, this will result in increased value at the time of withdrawal.
- Due to the huge amount of risk involved, returns for risky pairs will be high. Returns will be low for risky-stable pairs and very low for stable-stable pairs.
- Relevant tokens earned from farming can be exchanged in their token or can be used for the governance purpose of the particular platform.
The impermanent loss will not become permanent unless the liquidity pair is completely removed. While token-token pairs like BNB-CAKE will give you better returns, token pairs will Stable coins like BNB-BUSD may not give higher returns due to underlying stable coin.
Pl find the youtube short video on this : https://youtu.be/i8IznbxMK7Q
Note: we are not providing any financial advice and won’t be responsible for your losses in trading/staking or any other means, this article is meant for understanding purposes. Do Your Own Research before investing your money in cryptos.