What is Impermanent Loss and How to Mitigate It

If you've ever provided liquidity to a DEX, you've likely come across the term "impermanent loss." It's one of the most common risks associated with yield farming, and it can have a significant impact on your returns. In this post, we'll take a deep dive into what impermanent loss is, how it works, and how you can mitigate it.

What is Impermanent Loss?

Impermanent loss is the difference in value between holding two assets in a liquidity pool and simply holding them in your wallet. It occurs when the price of the assets in the pool changes, causing the ratio of the assets to shift. The more the prices of the assets diverge, the greater the impermanent loss.

The term "impermanent" can be misleading, as the loss is only realized if you withdraw your assets from the liquidity pool. If the prices of the assets return to their original ratio, the loss is reversed. However, if you withdraw your assets when the prices have diverged, the loss becomes permanent.

How Does Impermanent Loss Work?

Let's illustrate with an example. Suppose you provide liquidity to a 50/50 ETH/DAI pool. You deposit 1 ETH and 2,000 DAI, for a total value of $4,000 (assuming 1 ETH = $2,000).

Now, let's say the price of ETH doubles to $4,000. Arbitrage traders will step in to rebalance the pool, buying ETH and selling DAI until the pool is back to a 50/50 ratio. This will result in you having less ETH and more DAI in the pool. If you were to withdraw your assets at this point, you would have less than 1 ETH and more than 2,000 DAI. The total value of your assets would be less than if you had simply held your 1 ETH and 2,000 DAI in your wallet.

How to Mitigate Impermanent Loss

While it's impossible to completely eliminate impermanent loss, there are several strategies you can use to mitigate it:

• Choose stablecoin pairs: Providing liquidity to pools with two stablecoins (e.g., USDC/DAI) will significantly reduce your risk of impermanent loss, as the prices of the assets are unlikely to diverge significantly.
• Use single-sided liquidity provision: Some protocols, like Bancor, allow you to provide liquidity with a single asset, which eliminates the risk of impermanent loss.
• Hedge your position: You can hedge your position by shorting the volatile asset in the pair. This can be a complex strategy, but it can be effective in mitigating impermanent loss.
• Choose protocols with impermanent loss protection: Some protocols, like Thorchain, offer impermanent loss protection, which compensates you for any losses you may incur.

Conclusion

Impermanent loss is a real risk for liquidity providers, but it shouldn't deter you from participating in DeFi. By understanding how it works and implementing strategies to mitigate it, you can minimize your risk and maximize your returns.

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Disclaimer: The content of this blog is for informational purposes only. It is not investment advice. Please do your own research and consult with a qualified financial advisor before making any investment decisions. DeFi investments carry significant risks, and past performance does not guarantee future results. More details here.