DeFi or decentralized finance is a new concept that is gaining popularity in the crypto world. It is not just one of the hottest topics among traders but also has started gaining mainstream adoption among institutions and individuals. DeFi gives users access to numerous financial products like loans and derivatives, which were previously only available through traditional market makers. However, along with these opportunities comes risk—or rather the possibility of losing your hard-earned money because it might not be there tomorrow. What exactly does impermanent loss mean? How does this happen and how can we avoid it?
In traditional finance, borrowing or lending money through a broker (market maker) offers risk to the lender and borrower.
There are several risks to consider when borrowing or lending money through a broker (market maker). The borrower is exposed to interest rate risk. If the interest rate on their loan rises, they will be forced to pay more in monthly payments. On the other hand, if the borrower’s income increases over time and they can afford a higher payment, then they could save money by paying down their loan early.
The lender also has risks associated with lending money. They are exposed to credit risk which means that if their borrower cannot maintain timely payment of interest or principal on the loans they have made then they may lose some or all of those assets as collateral for any outstanding debt.
Additionally, traditional finance has limited liquidity options for both sides of transactions: lenders cannot easily sell off parts of their portfolio and borrowers cannot easily buy large amounts at once without affecting price or availability
In decentralized finance or DeFi, together with the opportunities comes with risk.
DeFi is a new technology that is built on top of blockchain. The combination of DeFi and the volatility of cryptocurrencies make it easy for investors to lose money in an impermanent fashion. There are three main risks associated with investing in decentralized finance:
- The lack of regulation
- The lack of transparency
- The high volatility
Impermanent loss is a consequence of the high volatility of cryptocurrencies. The concept behind impermanent loss is that the investor’s money invested in the DeFi protocol will not be returned to them if they liquidate their position at an unfavorable time. This can happen when an investor buys into an asset, but a few days later it drops significantly in value and then sells.
Why does impermanent loss occur in DeFi?
Many decentralized finance (DeFi) projects have been built by leveraging the Ethereum network and its smart contracts. In this manner, DeFi offers many benefits over traditional financial markets:
- Paying with crypto is as easy as sending a text message
- Without middlemen, costs are lower for both borrowers and lenders
- Loans can be paid back automatically in crypto; no need to pay interest or fees
How to avoid impermanent loss?
When investing in cryptocurrencies, there is an inevitable chance of loss if you store your assets through a standard DeFi liquidity pool. While currency exchange prices are always going to move, though, there are ways that the effects of impermanent loss can be mitigated.
Trading fees
Trading fees are collected from traders using the DeFi liquidity pool and a share of those fees are then rewarded to liquidity providers. As the number of trades increases, so too does their effectiveness—that is, it becomes more likely that they will be able to mitigate or offset any impermanent loss (and even turn it into a gain).
Through a certain point, if an investor staked more assets in a pool than he held directly, the fees collected would make up for losses incurred elsewhere.
Low volatility pairs
Volatile cryptocurrency pairings are likely to result in impermanent losses, but these losses can be mitigated by choosing a pairing where the exchange price is not volatile.
Stablecoin pairings, such as the Dai token’s pairing with Tether, have less price volatility than other coins and tokens. As a result of this stability, investors can avoid losses by holding these types of assets.
Other important facts about impermanent loss
There are a couple of extra details that any smart investor should review before making liquidity commitments to Decentralized Finance protocols.
Impermanent losses occur when the price goes against the position. If an investor withdraws digital assets before the exchange price falls, they can keep any value that was not lost. An impermanent loss is only realized when assets are withdrawn from an investment. The impermanent loss would disappear if prices returned to their prior levels.
Only when an investor withdraws his/her investment is the loss considered permanent.