Anyone who invests in a decentralized market (DeFi) has almost certainly heard of this term.
In fact, in an automated market maker (AMM) market, providing liquidity to a liquidity pool can be profitable, but the concept of temporary loss must be kept in mind.
What is temporary loss?
Impermanent loss occurs when you provide liquidity to a liquidity pool and the price of your deposited assets changes from when you deposited them. The bigger this change, the more you are exposed to a temporary loss. In this case, the loss means a lower dollar value at the time of withdrawal than at the time of deposit.
Pools that contain assets that remain in a relatively small price range will therefore be less exposed to temporary losses. Stablecoins, for example, will remain in a relatively low price range or coins with the same price change such as BTC and WBTC, In this case, there is less risk of temporary loss for the liquidity providers (LPs) in those pools.
So why provide liquidity if you are exposed to potential losses?
Well, the temporary loss can be offset by the trading fees, Indeed, pools that are quite exposed to temporary losses can be profitable thanks to the trading fees.
Uniswap, for example, charges 0.3% on each trade that goes directly to liquidity providers. If there is a lot of trading volume in a given pool, it can be profitable to provide liquidity even if the pool is heavily exposed to temporary losses. This, however, depends on the protocol, specific pool, deposited assets and even broader market conditions.
Below is a useful table to determine the impermanent loss based on the price changes compared to the initial conditions
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Disclaimer: This article reflects its author’s opinion only and is not financial advice. We take no responsibility for the results of any trader’s decision or action.