In the world of decentralized finance (DeFi), there are several ways to put our assets to work and make money from them, such as staking, yield Farming, providing Liquidity, lending and borrowing, etc. These earning ways are not devoid of risks, and so today, we will be discussing the risk associated with providing Liquidity on exchanges, known as Impermanent Loss.

But first, What does it mean to provide Liquidity on Decentralized Exchanges?

Providing liquidity on a decentralized exchange (DEX) means depositing a pair of assets into a liquidity pool to facilitate trading for that specific asset pair on the platform. For example, when one wants to buy Ethereum (ETH) on a decentralized exchange, he would likely use one of his assets to get the ETH, however, whatever asset he would be using, needs to have an existing pool on the DEX.

So let's assume, he has a stablecoin, say USDT; the trader would go to the ETH/USDT pool to exchange his USDT for ETH.

Liquidity pools are a fundamental component of DEXs and play a crucial role in enabling decentralized trading without relying on traditional intermediaries.

In the case of the ETH/USDT pool above, there is a need for enough Liquidity ( a supply of ETH and USDT) available, to facilitate trading and minimize price impact challenges when trading.

This is why people add Liquidity ( supply an equal monetary ratio of two assets ) to Decentralized Exchanges. You need an equal monetary pair of the two assets to be able to add liquidity, for example, to add a $100 Liquidity on the ETH/USDT pool, you need $50 worth of ETH and $50 USDT. They need to be equal not in quantity but in monetary worth.

Are There Benefits for Adding Liquidity in a Decentralized Exchange?

Liquidity providers earn a share of the trading fees generated on the platform, proportional to their contribution to the pool. They can also get airdrops depending on the Blockchain they are in.

What is Impermanent Loss?

Impermanent loss is a term unique to liquidity providers in DeFi platforms, particularly decentralized exchanges (DEXs). It refers to the temporary reduction in the value of an asset when compared to simply holding it, and/or, the value of the assets when they were initially supplied to the pool. This loss arises from the dynamic nature of liquidity pools, which are essential for facilitating trading on DEXs.

How Does Impermanent Loss Occur?

Impermanent loss occurs when you supply assets to a liquidity pool, and the price of those assets changes while they are in the pool. Essentially, as the pool rebalances due to trading activity, your holdings may become skewed, leading to a permanent loss when you withdraw your assets.

For example, if you supplied liquidity in an ETH/USDT pool and the price of ETH rose by 5%. If at this point you want to pull out your assets, the quantity of ETH you will receive will be lower than the quantity you supplied, and the quantity of USDT you receive will be higher. The monetary worth of the two assets will be higher than the monetary worth of the assets at the time you supplied them. If it is a case of price decline in one of the assets, the reverse will be the case.

It is important we know that there are daily rewards given to liquidity providers for their contribution to the pool. These rewards don't in any way affect the value of assets supplied. The rewards are incentives for adding liquidity. Mostly, DEXes pay these incentives using their native tokens. For example, Osmosis ( on the cosmos network) pays Liquidity providers in $OSMO. There can also be what is called external incentives that usually come from the underlying project behind one of the token pairs. So for a pool with external incentives, the liquidity provider earns dual rewards.

Is Impermanent Loss An Actual Loss?

Just as the name, " Impermanent '', one does not incur the loss until he pulls out from the pool. When the price of one of the assets drops or rises above the price upon which you supplied the assets, the impermanent loss will occur, and if you wait for the asset to correct back, the impermanent loss can be " likely" mitigated.

The problem here is the fact that the likelihood of escaping impermanent loss is slim. This is why most pools have higher APR to compensate for the loss.

Usually, the best time to pull out from a pool is when the price difference of the assets between when you supplied and the time you want to pull out is not much.

Conclusion

Providing Liquidity on Decentralized exchanges is very profitable, rewarding, and risky. One needs to bear this in mind before embarking on the journey. It is safer to join pools with a stable pair because you will only worry about the price fluctuation of one of the assets, unlike when you join a pool with two volatile assets.

For example, in the ETH/USDT pair, you will only worry about ETH volatility while in the ETH/UNI pool, you will be worried about the volatility of both assets.

#NFA.