How to Avoid Impermanent Loss in Liquidity Pools: Updated Guide

Liquidity pools are essential in decentralized finance. With liquidity pools, people can deposit their cryptocurrencies in a smart contract where others can trade their assets without using a traditional centralized exchange.

For providing this liquidity, liquidity providers are compensated with a share of trading fees and, in some cases, extra incentives. It is crucial to note that every liquidity provider faces a critical risk that is imperative to know: impermanent loss.

Impermanent loss refers to the changing value of the assets that have been put in the liquidity pools relative to their value at the time of depositing. The more prices of the assets vary, the higher the losses may be.

There are ways to minimize the risk, fortunately.

What is Impermanent Loss?

In simple terms, impermanent loss arises from the situation where the value of the assets held in the liquidity pool is less than that of the assets had you held them not in the liquidity pool.

The loss is termed as “impermanent” since it might reduce if there is restoration to the previous price relationship. But if the liquidity has been withdrawn when the price relationship exists, the loss is realized.

Let us assume you lock in an equivalent value of ETH and USDC into a liquidity pool. If the price of ETH increases drastically, the automated market maker changes the ratios of the assets in the pool.

As a result, the number of ETH will reduce while the number of USDC increases.

Why does Impermanent Loss happen?

All of the liquidity pools make use of an automated market maker (AMM) for pricing and liquidity purposes.

If you trade out one token from a pool, then the supply of that token within the pool falls down, whereas the supply of another token rises up. Arbitrageurs would come into play to balance out the price of the pool close to the market price.

This continuous balancing leads to change in the composition of tokens that you deposit in the pool.

The greater the price difference between two assets, the greater the impermanent loss becomes.

Choose Stablecoin Pools

One of the simplest ways to reduce impermanent loss is to consider pools containing assets with relatively stable prices.

For example, pools containing two stablecoins may experience much smaller price differences than a pool containing a volatile token and a stablecoin.

However, stablecoin pools are not completely risk-free. Stablecoins can lose their peg, and protocols can experience smart contract, liquidity, or other risks.

So, lower impermanent loss does not mean zero risk.

Look for Correlated Assets

Another strategy is to provide liquidity to pools containing assets that tend to move in a similar direction.

For example, two assets representing closely related versions of the same underlying asset may have less relative price divergence than two unrelated cryptocurrencies.

When the prices of both assets move together, the pool may experience less rebalancing than a pool containing highly volatile and unrelated assets.

Correlation can change over time, though, so historical price behavior should not be treated as a guarantee.

Avoid Highly Volatile Pairs

Pairs containing highly volatile assets can create greater exposure to impermanent loss.

If one token rises or falls sharply while the other remains relatively stable, the pool’s asset ratio can change significantly.

Before providing liquidity, consider how volatile both assets are and how likely their prices are to move apart.

Higher volatility may sometimes come with higher trading fees or incentives, but those additional returns need to be weighed against the risks.

Consider the Trading Volume

This is important due to the fact that liquidity providers are usually rewarded some part of the transaction fees.

A pool with high trading volume can create higher transaction fees that can be used to counteract impermanent loss.

Nevertheless, a high volume of trades will not guarantee the profitability of the pool. One needs to assess whether one can earn sufficient fees compared to the effects of price fluctuations.

A pool with low volatility but low trading volume will produce low fees, whereas a pool with high trading volume will subject one to price fluctuations.

Check the Fee Structure

There are different fees for each decentralized exchange and liquidity pool.

Check the percentage of trading fees that are shared with liquidity providers before adding funds into a liquidity pool.

It is important to note the presence of extra rewards in form of liquidity mining in the pool as well.

Such incentives will increase the total rewards, but you should not be guided only by such factors because token value could go down and incentives will eventually end.

Understand the Pool’s Liquidity Model

Not all liquidity pools function the same way.

The conventional CPMM liquidity pools risk exposure to price movements over a wide range. A newer type of liquidity pools allows the LPs to focus their liquidity in certain price ranges.

Focused liquidity has the potential to enhance the efficiency of capital usage but at the same time demands active management.

When prices move beyond your selected range, your liquidity will not earn any fee until the prices fall back into the range or you shift your position.

Thus, knowing how exactly the liquidity pool operates is crucial.

Don’t Ignore Smart Contract Risk

Permanent loss is not the sole risk connected to liquidity pools.

The DeFi protocol itself could have smart contracts issues, oracle issues, hacks, governance attacks, and many others.

One should investigate the track record of the protocol, smart contracts audits, development activities, total liquidity of the protocol, and security measures before entering a pool.

Even a tempting fee rate will not compensate for the risk of working with such a protocol.

Watch Out for High APYs

It is always tempting to earn very high yields, particularly for those who are new to the DeFi space.

High returns usually bring more risks than expected. For instance, the rewards could be paid out in a token that is highly volatile or in a pool that lacks liquidity. In addition, the reward program could be a one-time event.

Rather than just focusing on the stated APY, consider the source of the yield as well as its sustainability.

The lower yield from a known pool could be quite different from the extremely high-yield pool.

In a Nutshell

One cannot totally mitigate impermanent losses when liquidity provision to pools with fluctuating asset prices occurs. Nevertheless, there are ways to handle this.

Such things like stablecoin pools, correlated assets, moderate volatility, substantial trading volume, clear fee policy, as well as proper protocol research, can be helpful in this regard.

Most importantly, do not rely only on the published yield. You should learn how the pool works, how asset prices can affect your position, and whether trading fees and rewards will cover potential losses.

It is possible to earn money through liquidity pools, but these tools are not safe investments. One of the crucial issues before making deposits into such pools is to learn about impermanent losses.

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