What Is Impermanent Loss?

Since its inception, the crypto industry has been both fascinating and confusing. If you’ve been active in crypto or have been researching the way yield farms & liquidity pools work, then you might have heard about impermanent loss. So, what is impermanent loss, and how can it affect your journey with crypto?

In the simplest terms possible, impermanent loss happens when you deposit crypto into a liquidity pool and the price of the cryptocurrency in question drops. This means that you’re impermanently losing money (impermanent meaning temporary) as crypto prices fall compared to a fiat currency. So far, we’ve only touched the tip of the iceberg for impermanent loss. To learn more about it, continue reading.

Summary Of Important Points

• With the rise of DeFi, holders of crypto have started earning passive income thanks to liquidity pools and yield farms. This is done by “staking” cryptocurrency and giving it to a DeFi platform for a modest return.
• Impermanent loss happens after you stake your money in a liquidity pool (or a yield farm). This is because the price of the cryptocurrency in question has changed - the bigger this change is, the more money you’ll lose.
• Impermanent loss is usually temporary. Since yield farming and providing liquidity are profitable ventures, you’ll get your lost money from the impermanent loss within a short time (when the cryptocurrency stabilizes, you get some or all of your money back). Still, it's one of the risks of providing liquidity.

How Does Impermanent Loss Occur?

Now that we’ve got the basics out of the way, let’s talk about the details - how does impermanent loss exactly happen? Let’s take the following example of a liquidity pool.

Imagine that you’re depositing 0.1 BTC and 10 BNB in a liquidity pool, considering that 0.1 BTC is equal to 10 BNB (when depositing in a liquidity pool, the pair usually has to be of equal value). With the money you’ve deposited, you’ve gained a share of the liquidity pool. Usually, liquidity pools have values of as much as a million dollars in them, so unless you’re a crypto whale, you’ll have a small share of the pool.

As you’re holding the crypto in the pool for, let’s say, 12 months, the price of BTC increases by 20%, but BNB’s value stays the same. The traders in the pool keep buying more BTC but leave the BNB. After a year, the pool gives you a reward of 10% in BNB, yet if you held BTC, you would have had a profit of 20%.

So, in this scenario, you would’ve been better off holding your BTC rather than depositing it in a crypto pool to “earn” passive income for you. Sure, you’ll make a profit either way, but the difference of the 10% is the impermanent loss we’ve been talking about.

Still, keep in mind that this scenario is highly specific and very unlikely to happen. Even if the impermanent loss occurs, the chances are that the crypto market will eventually correct itself with an upward trend and will cover the loss for you.

Does Impermanent Loss Lead to Losing Money?

Whether you’re holding your crypto in a private wallet or using it to gain interest with liquidity pools or yield farms, you’ll make a profit. In the scenario we’ve described above, both outcomes lead to a profit, yet holding your crypto gives a slightly bigger one.

So, the truth is that impermanent loss doesn’t lead to losing money, but it can cause you to gain a smaller profit. The size of the impermanent loss also largely depends on the volatility in a trading pair, so choosing your crypto wisely before staking it is the best way to avoid this type of loss from happening.

Keep in mind that with impermanent loss, there are no rules set in stone. Over the years, the crypto market has been doing fascinating things, so chances are, your impermanent loss will probably correct itself, and when the time is right, you’ll close your positions for a profit.

There are many ways to mitigate impermanent loss. If you’d like to avoid the possibility of impermanent loss at all costs, consider checking out an online impermanent loss calculator and get an overview of how much providing liquidity might cost you. However, in most cases, the impermanent loss does not lead to losing any significant amount of money.