06.01.2023 |
Updated January 6, 2023
Temporary loss is a risk that comes with participating in DeFi liquidity pools. This happens when the price of your deposited assets changes from the time you deposited them.
What is Impermanent Loss in Crypto?
It refers to a situation where the profit you make by staking a token in a liquidity pool is less than what you would have earned by just holding the asset. This happens when a token’s price changes in the market, causing your assets deposited in the liquidity pool to become worth less than their current value in the market. The larger this price change, the more exposed your assets are to volatile losses.
For example, if the value of the assets in the pool decreases by 10%, but the value of the LP tokens only decreases by 5%, the user has suffered a temporary loss of 5%.
It indicates how much more your wealth would be worth if you only provided HODL instead of liquidity. This gap is “volatile” as it is possible to close the gap if the token price returns to the previous price. It is also important to note that the temporary loss does not take into account trading fees that investors earn for providing liquidity, which in many cases can negate losses.
How does it work?
First, it doesn’t necessarily prevent liquidity providers from making profits. This loss is only tangible if investors withdraw their liquidity from the pool at this precise moment. Pools often employ strategies to try to make up for this loss, such as: B. Charging high fees to get more profit. Therefore, liquidity providers make more of fees to cover their fickle loss.
However, in the event of a significant price difference, your fee gain may not cover the loss. In this case, you would have gained more value by holding the assets rather than providing liquidity.
Let’s see an example:
- Suppose you deposit $500 worth of ETH and $500 worth of BTC ($1000 total) into a $10,000 ETH/BTC liquidity pool with a 10% stake.
- Suppose the price of ETH increases to $800 after your deposit; The pool is thrown off balance, opening up space for arbitrage traders.
- The value of the liquidity pool increases to $12,000 when balanced again. If you withdraw your tokens at this time, you will receive 10% of the pool, which equals $1200.
Even if you appear to have made more profit, your profits may be less than the base value shift of your tokens. Due to the price increase, the value of your deposited ETH increased from $500 to $800 while your BTC balance remained at $500. So if you held your fortune, your total profit would have been $1300 ($800 + $500). You would have earned $100 more if you hadn’t participated in the liquidity pool. This is what we call impermanent loss.
How to calculate temporary loss?
Calculating your exact loss can be a bit tricky due to the complexity of some of its variables. But you can estimate your loss with the following formula:
Temporary Loss = 2 * sqrt(price_ratio) / (1+price_ratio) – 1
The price ratio is the ratio between the token price on deposit and withdrawal.
how to avoid it
While you can’t avoid a temporary loss, you can reduce the risk. Here are some helpful tips:
- The more volatile the assets, the more likely it is that temporary losses will occur. Use more stable tokens like stablecoins or BTC to reduce the chance of a temporary loss.
- Make sure you also use proven automated market makers to reduce your risk of market manipulation.
- Start by investing a small amount to diversify your portfolio and reduce the percentage of your wealth that is exposed to volatile losses.
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