Factor in impermanent loss when seeking better returns for your crypto portfolio.

Your money should do more for you. For cryptocurrency users, one common approach to growing your crypto is to put your tokens in a liquidity pool. But what is impermanent loss in this scenario and how do you avoid it?

This article will explain the basic concepts of where and how you might run into this risk and what to do about it.

First, we’ll start by defining a few foundational concepts, beginning with decentralized finance or DeFi.

What Is DeFi?

Decentralized finance is a relatively new innovation that enables peer-to-peer transactions between individuals without a centralized intermediary — a bank, for instance.

Want a loan? Connect with someone willing to make the loan through a DeFi app and accept their terms.

Want to buy something from someone online? Connect and pay directly via a DeFi app without using a bank or payment service — and without either of you paying their fees. Want to trade goods or services? The same logic applies.

But how does DeFi make this possible? And what does this have to do with putting your cryptocurrency to work for you?

DeFi runs on two primary technologies: cryptocurrency and blockchain. Blockchain is an automated, distributed ledger that facilitates verifiable, immutable transactions. But DeFi has one particular sore spot: liquidity.

Liquidity is the ease with which you can buy or sell something.

Consider selling a used car. You want to sell it for $500. You advertise it for sale and hope someone sees your ad and is willing to pay that price. It can take time to find a buyer. That’s not liquid.

In traditional financial markets, market makers provide liquidity by being ready to buy and sell assets at posted prices. They add a small markup to cover the risk of holding the assets to sell.

In a sense, whenever you want to buy or sell an asset, you can count on there being someone ready to sell you theirs (or buy yours). But in the world of crypto and DeFi, there are no such intermediaries. So, part of this necessary function is covered by liquidity pools.

Users fund a liquidity pool with cryptocurrency that can then be bought, sold, or borrowed by other users. You might think of it as a ready stash of cryptocurrency that saves the time and effort of finding and connecting with buyers or sellers.

In this world of decentralized finance, liquidity pools contain smart contracts so that exchanges can take place automatically and without the need for an overseeing intermediary. Those who fund a liquidity pool with their crypto earn a return for doing so.

You’ll probably run across three terms — sometimes used interchangeably — to describe how these users earn a return on their crypto: staking, yield farming, and liquidity mining. However, they all have slightly different meanings, and not all are subject to impermanent loss.

Let’s take a closer look.

3 Ways to Earn a Passive Return on Crypto

Staking is a very broad term that can technically encompass the other two (yield farming and liquidity mining) as more specific instances of it.

But, in its simplest form, staking is committing your crypto to support the workings of a blockchain — specifically to confirm transactions. In turn, stakers earn rewards.

Yield farming also involves committing your crypto but, in this case, to a liquidity pool operating on the blockchain. For this, you would earn a percentage of the transaction fees charged by the pool for those using it.

Liquidity mining is a special subset of yield farming. Here, in addition to a share of transaction fees, your cryptocurrency would also earn rewards in the platform’s own token offering.

Generally speaking, staking is not subject to the risk of impermanent loss. However, yield farming and liquidity mining can expose you to this risk.

But how do liquidity pools actually work? That’s where an innovation called an automated market maker (AMM) comes in. It’s also where the risk of impermanent loss arises.

AMMs, Trading Pairs, and Stablecoins

In fully automated DeFi and liquidity pools, traditional market makers don’t exist. So there needs to be some way of setting prices between buyers and sellers.

An AMM is a protocol embedded in smart contracts that facilitates transactions in a liquidity pool. Most rely on an important concept: initial crypto deposits in the fund are in pairs of cryptocurrencies that have equal overall value. For example, Ether (ETH) and DAI, the latter of which is considered a stablecoin.

Stablecoins are cryptocurrencies that attempt to have their value pegged to a fiat currency to provide stability. DAI, for example, aims to maintain a 1:1 ratio with the U.S. dollar. Why pairs of crypto? This facilitates the automation and rapid transactions between cryptos without having to first convert them to some other currency, such as U.S. dollars.

Impermanent loss arises because of fluctuations in the value of one crypto in a trading pair compared with the other.

What Is Impermanent Loss?

If prices were to remain unchanged, there would be no risk of impermanent loss in liquidity pools. But the world of crypto is rife with price fluctuations.

Why is this a problem?

If you deposit your crypto in a liquidity pool, you expect to earn a return, but it’s possible your committed crypto could lose value.

In a liquidity pool, the ratio of value between crypto pairs must remain stable. In the ETH/DAI example, if you initially deposit 1 ETH worth $100, you must also deposit $100 of DAI (100 DAI).

Your total initial investment is worth $200.

If the total pool is $2,000, you are entitled to 10% of the pool’s transaction fees. So far so good. But what happens if the price of ETH changes?

Let’s say the price of ETH on external markets quadruples to $400, or 400 DAI (since each DAI presumably continues to be $1). Arbitrage traders will take advantage of the price disparity and trade it out  and add DAI until the original ratio is restored. Across the entire pool, 5 ETH and 2,000 DAI.

If you decided to withdraw your funds at this point, you’d get 10% of the fund — your share: 0.5 ETH and 200 DAI. 0.5 ETH at $400/ETH equals $200; 200 DAI equals $200. So $400 total. Since your initial deposit was $200, you’ve doubled your money — great, right?

But what would have happened had you just sat on your initial crypto (HODLed it) without putting it to work for you? Your 1 ETH would be worth $400, and your 100 DAI $100, for a total of $500. In this scenario, you would have experienced an impermanent loss of $100.

We’ve ignored any potential profits you might have made from your share of the pool’s trading fees. They might have exceeded the $100 loss. But they might not have. In fact, in some scenarios, it’s possible to lose some or much of your original deposit.

But since the loss is impermanent, it’s not forever, right? Can you get it back somehow?

Well, it’s not really that kind of impermanent. Once you withdraw your funds, any “impermanent loss” becomes very permanent.

The impermanence refers to what can happen if you leave your funds in the pool. If at any point the price ratio between the crypto pair reverts to its original ratio, the impermanent loss will disappear. In the example above, if ETH dropped back to $100, all would be well.

But there’s the problem: Cryptocurrencies are infamously volatile. So you have to expect price variations to occur.

Why Provide Liquidity?

By answering “What is impermanent loss?” and sharing tips for how to avoid it, you can feel more confident on your investment journey. Just remember that trading, by definition, includes some degree of risk.

Having the right crypto platform partner, like Binance.US, can help. From offering education and insight into the intricacies and risks of crypto trading to offering a secure, simple user experience, choosing the right platform can make all the difference.

To start your crypto journey, set up an account on Binance.US today.

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