The secret to succeeding in cryptocurrency is in understanding all its aspects. Impermanent loss is one of the things that any crypto trader should be conversant with. There are times where the volatility in trading pairs may cause temporary loss to the liquidity provider; this is what is known as impermanent loss. Decentralized finance is becoming popular and this has attracted quite a number of liquidity providers like PancakeSwap, SushiSwap, and UniSwap. These platforms provide an opportunity to users with funds to become market makers and they can earn from trading fees.
Sadly, one of the challenges with these Automate Market Maker protocols is the fact that you can lose your funds for just holding them. As such, this means that at the time of the withdrawal, you will get a lesser value than what you had deposited. Understanding permanent loss is a concept that you need to know if you have intentions of trading as a market maker.
The Concept Impermanent Loss
As stated earlier, an impermanent loss is one of the serious risks that come with the liquidity protocols in decentralized finance. In simple terms, this is a type of loss that traders incur when there is a difference between the funds in your crypto wallet and those in the AMM. If you have funds staked in Automate Market Marker protocols and the value fluctuates, you will suffer an impermanent loss. The volatility in trading pairs will cause price fluctuations and this prompts a temporary loss. This is one of the key reasons why some potential investors shy away from putting liquidity to the pools.
It is important to understand that automated market marker protocols are not connected to the external markets. As such, where there is a price fluctuation on the external markets, they will not affect prices on AMM. This means that you could be bitcoin circuit but the events on the market have no impact on AMM. The price fluctuations on AMM occur when traders buy assets that do not have a price or when they sell overvalued assets. The arbiters will make profits from these changes and this causes a permanent loss. As the name implies, this is a temporary loss and not the end of the game. As a liquidity provider, you can actually be able to recover your money from such a loss.
How Liquidity Providers Recover From Impermanent Loss
Well, losses are scary for any investor who hopes to make money from an investment. When an impermanent loss affects you, there is a chance to get back your funds. The only way that this happens is when the price of the specific asset reverts to the original price on AMM. Should this happen, then you will be out of the temporary loss and can actually make 100% of the trading fees. However, there is a very slim chance of this happening and sadly, a temporary loss leads to permanent loss of your funds.
How to Prevent an Impermanent Loss
One of the best ways of protecting your funds from losses is to invest in stablecoins. Liquidity pools that offer stablecoins as liquidity are bound by smart contracts. As such, they are less volatile and significantly reduce chances of permanent loss. The other option that can help you avert impermanent losses is looking for liquidity pools that provide arbitrary weights. As a way of protecting investors, most pools recommend depositing two assets in the ratio of 50:50 or 80:20. This also serves as a shield against the heavy impact of impermanent loss.
There are so many benefits of the decentralized finance ecosystem. However, there are also possible risks like impermanent loss, and as such, it is imperative to ensure that you have sufficient information before venturing into cryptocurrencies.