Fleeting loss has become a curse, but what does that actually mean?
Providing liquidity to AMMs like UniSwap and SushiSwap has been a constant theme since DeFi boomed in 2020. Becoming a liquidity provider opens up new opportunities for a vast majority to make money that previously did not have the opportunity. Who doesn’t like the idea of being able to live on passive income? However, the concept is intriguing and has received negative light in the community. To be honest nobody likes losses so that’s fair. In order for you to understand the idea of temporary loss, you need to understand what a liquidity pool and liquidity provider are. (If you are already crypto-native and know this, you can skip this part.)
What is a liquidity pool?
A liquidity pool is a pool of different crypto assets locked in a smart contract. They allow anyone to become a market maker and facilitate trading on decentralized exchanges (DEX) in a permission-free manner. In order for liquidity pools to be able to develop their full functionality, you need liquidity providers. The liquidity providers are doing what it sounds like. They provide liquidity to the liquidity pool and earn a portion of trading fees each time people use the liquidity pool to trade between tokens. The amount of fees they earn depends on the amount of pool they own. Also, these pools are constantly re-balancing, ensuring that both assets are of equal value. So if you have 10 bitcoins in the pool worth 30,000 each, then the other side of the pool might have a USDC value of 300,000.
Liquidity pools are the backbone of DeFi and solve the liquidity problem that forces people to use high slippage. It has allowed people to bypass centralized exchanges (CEX) and trade without order books as no counterparty needs to hold the exchangeable assets and match people’s orders. Instead of trading peer-to-peer using an order book, you are now trading peer-to-contract using a smart contract.
If you have been into crypto for a while you have seen random tokens that have skyrocketed in price but when you try to sell there is no liquidity. On the other hand, there have been people who have maximized their slippage and performed swaps, and the result is that Rekt users are getting little bang for their buck. This is the main problem when there is insufficient liquidity on decentralized trading platforms.
If you don’t know what I’m referring to, here is an example of the airdrop fees and someone losing 850 ETH and getting rect with slippage: https://etherscan.io/tx/0xde78fe4a45109823845dc47c9030aac4c3efd3e5c540e229984d6f7b5eb4ec83
With that in mind, I mentioned that you can earn trading fees if you are a liquidity provider. This brings us to the main theme of this piece, impermanent loss.
What is Impermanent Loss?
The simplified version of impermanent loss is: the loss you incur by being a liquidity provider instead of holding the tokens in your wallet. How does this happen? If you are a liquidity provider you want the assets to hopefully have stable price movements and not have large price changes against each other. Because of this, it is common practice for one of the two assets in the liquidity pool to be a stablecoin. This ensures that in most cases you don’t have large temporary losses. A high risk liquidity pool would look something like Ethereum x Dogecoin. Two highly volatile assets that can swing either way.
Remember that liquidity pools are constantly rebalancing to maintain an equal share of both assets in the pool. So if the aforementioned bitcoin increases in price, more bitcoin will be sold for USDC to keep the pool balanced. The ratio between the two assets will change and depending on your stake in the pool, you may receive less value from the pool when you call it off. For this reason, the incentive to do this is the return that is also made in the form of yield operations.
Photo by Markus Winkler on Unsplash
Nonetheless, people mostly mention temporary losses in the cases where they lost more money due to the constant rebalancing. However, it can sometimes work in your favor as well. If the volatile asset, which is BTC for example, falls in value instead. The liquidity pool is automatically rebalanced and “buy the dip” automatically. So averaging down. Although it limits gains to some extent due to rebalancing, it also limits losses.
It’s usually only spoken in terms of losing money (duh, it’s called impermanent loss) when the liquidity pools you enter should be between stable assets to limit this. The more volatile assets you have in your pool, the higher the risk of temporary losses, which is why you usually reward them with a higher return as well.
However, if you want a stable method of increasing value over time, LPing is a good option once you’ve carefully considered the pros and cons. If the return combined with that is lucrative, then it’s worth considering. However, before stepping into a yield farm that requires LPing, you should use a fickle loss calculator to look at the various options that are presented to you. You can use it to see the losses received as the coins move or fall and calculate them against the yield received to see if it’s worth it. The volatile loss calculator can be found here.
Finally, if you are a tactical person looking to get in and out of LPs when times are good, you should exit LPs when you think the asset is at the “bottom” of its downtrend. The best way to do this is to exit the LP and go down on one-sided staking to maximize your yield (easier said than done). The reason for this would be that you would expect the pair’s volatile asset to reverse and then appreciate in value.
The same applies to top signals. If you provide liquidity to LPs that have recently had a strong move higher, you risk losing liquidity as people trade their wealth for stables to take profits. It’s a complicated business even for the best traders.
What do you think of fickle losses? Let me know in the comments below.
I want to make it clear that although I am a financial professional, this is not financial advice and this article is only intended to shed light on the current market situation. I advise everyone to do their own research, I just want to help you find what you are looking for. If you liked this piece, please feel free to share and subscribe.
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