Attractive Gains Met By Significant Loss
Many people have chosen to avoid the whole idea of yield farming or liquidity mining due to the significant risks associated with the sector. DeFi has been and continues to be a very active avenue of the Crypto space, with many predicting significant growth in the years to come. I too believe that this is just the start of something that will dramatically change finance in the years to come. Attractive gains are obviously the biggest draw card to the sector, with many opportunities offering insane returns. However, many do not consider the losses that are at hand as they only consider the risks. In this scenario, a rug pull or exploit would be considered a risk but a loss can take place without any of these dynamics taking place.
A loss can take place even when the price of an asset increases. This is referred to as Impermanent Loss and can be a hidden enemy lying in wait to attack the value of your assets.
Impermanent Loss & How It Works
When providing liquidity on any Automated Market Maker, deposits need to be of equal value. The AMM protocol operates on a formula to adjust holdings in relation to price movement. In essence, the purchasing of an LP token is purchasing a percentage of the pool. The algorithm or formula adjusts the ratios of the assets in order to keep the distribution equal. What this means is that if one of the assets happens to see a significant appreciation in price, the holdings will actually be altered to reflect that adjustment. This can cause liquidity providers to actually come out of the contract with less tokens than they initially invested if they choose to withdraw the liquidity at those prices. However, if an investor chooses to wait and prices return to the original levels at which they deposited, they will be able to withdraw the same amount of tokens as they deposited.
So How Can We Avoid This Dynamic?
There is a very simple approach or strategy to implement in order to remove the risk of impermanent loss and that is to use stable coin pairings, such as BDO/BUSD or some other stable coin pair.
These coins are not supposed to increase in value and even when they do it is usually a percent or two. Perhaps BDO is not the best example as it is known to move outside of the prescribed range. A pair such as BUSD/USDC is probably a better option for such a scenario, as a move over a percent would be considered large. I have seen many who chose to provide liquidity with more volatile assets such as Compound and exited the protocol worse off than if they had simply held those 2 assets in their wallet for the same time period. This means that even after the compounded returns, the impermanent loss became realized loss and put them in a worse position than simply hodling.
This can be avoided by utilizing stable coin pairings and many offer really impressive returns as well. Perhaps something to consider if you have experienced this dynamic play out in your ventures. This is however not investment advice. Please do your own research and make informed investment decisions.