Understanding Impermanent Loss


Understanding Impermanent Loss

Imagine our shock when we discovered that processing liquidity doesn't mean a guaranteed future as we watched millions of staked tokens lose value before our very eyes. It seemed better with the old technique where we just held our tokens. But understanding the unfazed advent of the automated market maker (AMM) technology plays a significant role in helping to overcome 'impermanent loss' (the term used to define the risk that DeFi's many liquidity providers run every time they try out a basic buy-and-hold strategy).

In order to get the way to circumvent this risk, we must first know the enemy. So, what is Impermanent loss?

What is Impermanent Loss?

Impermanent loss is the degree of deviation between the token value in an AMM and the value of a token kept in a wallet. The rather optimistic 'impermanent' part of its name is simply to acknowledge the rare possibility that the relative token prices in an AMM will go back to their initial state (the value when you placed the token will then replace the loss and you even get 100% of the trading fees in addition). 

The sky is not that blue, however, and that's why liquidity providers often lose their capitals in that process, in addition to negative returns on the investment.

What Causes Impermanent Loss?

The roots of Impermanent loss are the arbitrageurs. It is common knowledge that AMMs are not bound by fluctuating market rates. However, changes in token prices still reflect in the disconnected AMMs. So, how does that happen? 

It turns out that arbitrageurs manually adjust AMM prices by purchasing underperforming assets or selling the overpriced ones until the AMM prices reflect the external market prices. Not seeing how that relates to impermanent loss? Well, that's because arbitrageurs customarily choose to make their profits from the invested assets of liquidity providers. That shortage is called impermanent loss. 

How to Mitigate Impermanent Loss

To avoid impermanent loss, the more advanced traders have taken to keeping hawk eyes on any flux in AMM prices, with their intentions clearly geared towards avoiding losses. Of course, there are less hectic ways to inhibit impermanent loss. One is to regulate the price divergence.

If the token price difference between pieces in the AMM and the external market is the driver for impermanent loss, then minimizing that widening gap is crucial to relaxing the risk of impermanent loss. 

As long as AMM tokens don't run out of commission and the relative prices of both external market tokens and AMM tokens remain consistent with each other, there's no need for arbitrageurs in the equation. Liquidity providers can then start thinking about earning money from their trading fees. To prove that theory, tokens that retain a consistent price range (with respect to the external market mirror assets) always turn out to be an effective repellent for impermanent loss. Of course, these systems need to be appropriately optimized for the profit of the liquidity providers. 

This means that providers must always withhold an amount designated to be a 'backup asset' when they're thinking of investing liquidity in synthetic tokens and stablecoins. Many developers have created Chainlink price oracle integrations to peg reserves for liquidity providers and maintain the AMM token price in stasis. They only change with respect to the external market prices flux based on the readings of the oracles, which means bye to the arbitrageurs. 

By using such a design, liquidity providers can fearlessly invest in volatile tokens again without fear of impermanent loss, just as much as they would with stable tokens. And this rules out the defensive move of holding synthetic assets when one would otherwise stake, which can even be a 100% liquidity provision for token exposure in AMM. 

Bottom Line

As long as the problem of impermanent loss is mitigated, liquidity provision in AMMs can relaunch towards its true potential. On that foundation and through investors with the latent capital to actually make it a passive market, the newly improved and risk-minimized AMMs can now truly become the biggest answer to catalyzing the growth of decentralized liquidity. 

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