Oh come on! This is the third blogpost this week on the likes of impermanent loss already. While I prefer keeping all my blogposts between 1000-1500 words so that our readers don’t feel bored or less informed at the same when they finish the topic, but impermanent loss is different. You see, for a new entrant the journey starts with a centralized exchanged like CoinDCX. Things are rather simple there. But when it comes to something like impermanent loss, it is a complex topic that personally took me about 3 days to completely wrap my head around it. For the uninitiated, impermanent loss is the temporary loss incurred by the liquidity provider as compared to just “buy and hold” strategy. This is primarily because of the way a constant product automated market maker works. If you are wondering what these words mean, here’s something that we recently covered so that you can have a dining table conversation with your family on Automated market makers.
Coming back to the topic of the day. If there is going to be an impermanent loss, why would someone invest their money in a liquidity pool? Why not simply hold the crypto? While the fees most likely compensates for the impermanent loss, there are some inherent ways to avoid it. This blogpost specifically talks about these 5 ways to avoid impermanent loss. So let’s get started:
A. Provide Liquidity to Stable Coins:
The major reason behind the impermanent loss is when the price of the two cryptos that you have provided liquidity for, changes, relative to each other. So, if one crypto starts going up and the other one starts going down, you are likely to make an impermanent loss. If one crypto is stable and the other one goes up or down, you still expose yourself to impermanent loss.
Therefore, by now, anyone would have guessed that if you provide liquidity to stable coin pairs like USDT and DAI, you are unlikely to face an impermanent loss. Why? Because these stable coins barely fluctuate in relation to each other. With that being said, you and I are not the first person to discover this phenomena. Therefore, most of liquidity pools with stable coin pairs are either full OR provide very little ROI. Once again, investing in stable coin pairs is one of the safest way to invest in liquidity pools.
Oh, I almost forgot. With the safety tag comes an asterixis (conditions apply). The stable coin you are investing in shouldn’t collapse. How does a stable coin collapse you ask? USDT or Tether is under scrutiny for a while now. Multiple reports claim that it is over leveraged and does not have dollars in 1:1 ratio in it’s reserves. You can find the latest Bloomberg report on this subject here. Another stable coin, Iron Finance dropped to zero earlier this year.
B. Avoid Risky Tokens:
Now risk is a very subjective term. However, that won’t stop us from coming up with some thumb rules. So, if you are planning to invest into a liquidity pool with extremely volatile coins, just hold back and rethink. Similarly, avoid investing in new coins when it comes to providing liquidity as the price discovery is yet to happen for them. So, if they move in either direction, you expose yourself to impermanent loss.
C. Time The Market:
Well, this is not something which is advised by market gurus. But if you can do so, invest in liquidity pools when the coin price is low. If you provide liquidity during the bear market the impermanent loss that you would incur would be at least when the overall value of your investment is going up as opposed to going down.
Please note that you are still going to face the impermanent loss like this but you would at least have the token appreciation going for you.
D. Incentivized Liquidity:
Impermanent loss is inevitable when the prices fluctuate. So, find something that would help you mitigate that loss. There are liquidity pools that provide fee + extra incentives for providing the liquidity. This is generally done by newer exchanges to lure the investors. This incentive is generally in the form of native token of the platform.
Please note that the price of this new token might be speculative, extremely volatile and can go to zero.
E. Tweaking Pool Ratio:
Most of the platforms allow you to provide liquidity in 50/50 ratio. But what if you could do that in a different proportion. Say 80/20. That way, you could stake more of it in a stable coin. There are platforms like balancer that allow you to do just that. As a matter of fact, they allow you to pick the proportions like 98/2 for providing liquidity.
Next time someone comes across and asks you if his/her investment in Doge will double or not, show them an article like this so that they can understand that cryptoverse is not a get rich quick scheme. On that note, I hope I did a good job of explaining how to avoid impermanent loss.
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Until next time..
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