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Crypto Basics #13: What is Impermanent Loss?

By 2sats | 2sats | 15 Aug 2022


*obligatory not financial advice*

 

Hi,

In this series I want to explain some terms that are relevant to the amazing world of cryptocurrencies to help newcomers understand it better. Today I want to talk about what impermanent loss is.

 

Previous Parts:

Crypto Basics #1: What even is a Blockchain?

Crypto Basics #2: What are Smart Contracts?

Crypto Basics #3: What is a Cryptocurrency Wallet?

Crypto Basics #4: What is Mining and Proof of Work?

Crypto Basics #5: What is Staking and Proof of Stake?

Crypto Basics #6: What is a Decentralized Exchange? And how do they work?

Crypto Basics #7: What are Stablecoins? And How do they work?

Crypto Basics #8: What are Coins and What are Tokens?

Crypto Basics #9: What even are NFTs?

Crypto Basics #10: What is Yield Farming and Liquidity Mining?

Crypto Basics #11: What is the Bitcoin Halving?

Crypto Basics #12: What is a Fork in the Crypto World?

 

What is Impermanent Loss?

A decentralized exchange works by letting users provide their cryptocurrencies to trading pairs that traders can use in exchange for a trading fee. People that provide this much needed liquidity are Liquidity Providers and while they do earn fees and often also farming rewards, they are at risk of impermanent loss.

Impermanent loss happens every time the ratio, or price relative to each other, of two tokens in a trading pair changes drastically. In this case it could be that the liquidity providers would have kept more value if they had kept the two tokens separate. That is because a decentralized exchange sets its prices based on the ratio of the supplied tokens.

For example if a liquidity pool on Uniswap would have 10 ETH and 10,000 USDC then you could trade 1 ETH for 1,000 USDC, but should 5 ETH be sold and 5,000 USDC added to the pool then you could trade 1 ETH for 3,000 USDC. It works the same for suppling liquidity, so if you supplied 10% of the liquidity to the pool then you would had originally 1 ETH and 1,000 USDC and then after 5 ETH were sold you would have 0.5 ETH and 1,500 USDC in the pool. So you lose some amount of the token that increased in value and gained more of the other.

In this example you initially invested a total value of 2,000 USDC and later your investment had a total value of 3,000 USDC, which sounds nice but if you wouldn’t have supplied the liquidity it would have a value of 4,000 USDC because your 1 ETH alone would be worth 3,000 USDC at that time but your ETH share of the pool became smaller.

This can even the worse if you supply liquidity to a pair of two tokens that neither are a stablecoin, in that case it can happen that one token increases in value while the other losses value and the impermanent loss is worse. That’s why if you want to supply liquidity to a DEX you should try to pick a trading pair were you think both tokens will increase in value together or will keep their ratio.

However, the liquidity providers do also earn trading fees that are added to their share of the pool and they can earn farming rewards which can compensate the impermanent loss that they might experience. Impermanent loss is also not permanent, because the ratio of the tokens and their price might change again to what they were when you supplied the tokens, in that case you were not harmed by impermanent loss.

 

I hope that short explanation was helpful for some newcomers. I will keep writing more such short articles about various crypto terms. Feel free to follow me if you are interested.

 

 

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I am just some bored guy that likes crypto


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