Impermanent loss is an issue many traders grapple with in the defi space; it is one of the weaknesses of decentralized finance when an automated market maker  is used to execute trades.

There are solutions to the problem, and Dexfolio's dApp helps traders to monitor losses and keep watch on their portfolios, but there are also other things they can do to ensure that they don't lose money after providing liquidity to liquidity pools.

But first, it helps to understand how liquidity pools work and how impermanent loss occurs.

How Does a Liquidity Pool Work in Defi?

Liquidity pools are vital to the operational structure of many decentralized exchanges. Uniswap, Pancakeswap and other decentralized exchanges on the Binance Smart Chain or the Ethereum blockchain use liquidity pools as the backbone of their protocols.

Liquidity pools consist of pairs of tokens held within a smart contract, and these can be used for different protocols within the defi system such as lending or trades.

Liquidity providers place their tokens into a liquidity pool for the use of the market, and in return, they receive a reward. Those tokens are then available for anyone to use, subject to the rules of the protocol.

LPs must Provide Liquidity as Tokens of Equal Value

Two assets are deposited into the pool and the liquidity provider must ensure that they are of equal value. For example, if the pool consists of ETH and DAI tokens, 1 ETH token might be worth the same as 100 DAI tokens. So the owner must ensure that the correct ratio of tokens is added to the pool.

What Happens when Liquidity Provision must be Maintained?

If an order is placed for one of these tokens but not the other, this creates an imbalance in the pool and the automated market maker is the solution to this problem. It creates an automatic price adjustment according to a deterministic pricing algorithm. Different protocols use different algorithms, but the basic principles remain the same. The main purpose for this is to maintain liquidity within the pool.

There are variations on the rules and the way liquidity pools work, but this is an explanation of how a basic liquidity pool operates.

But why is it tied to impermanent loss?

What is Impermanent Loss (IL)?

The idea behind liquidity pools is simple: liquidity providers supply tokens and traders get to use them whenever they want. In return for their liquidity provision, LPs get a cut of the trading fees, earning them a passive income.

But there is a catch when utilizing this strategy, a weakness inherent to decentralized finance.

Liquidity Provision can be Risky

There's no guarantee that liquidity providers will make a profit due to the volatility of the crypto assets market and the nature of the automated market maker. In its attempts to rebalance the liquidity of a pool after a trade, the algorithm can leave liquidity providers out of pocket as they sustain a loss on their original investment. Liquidity provision can be a high-risk activity depending on a user's skills and choices.

This situation is called impermanent loss (IL), so-called because it only becomes permanent if a liquidity provider closes a position while still in the red. Things can quickly turn around in the volatile crypto world and a loss could be regained soon after. However, the risk of further losses remains a real threat.

Impermanent loss occurs when it would've been better to hold tokens in a wallet rather than providing liquidity. Dexfolio users can easily monitor losses and keep track of market movements to help them avoid impermanent loss.

Is Providing Liquidity Better than Holding Tokens in a Wallet?

To decide if it's better to provide liquidity or hold tokens in a wallet, there are some key things traders should consider before making a decision.

1. Is the asset a blue-chip currency like ETH or WBTC? While these assets may experience volatility, smaller coins have a much higher chance of suffering losses due to even higher volatility. Is the potential for loss (or little profit) greater by holding in a wallet or subjecting the asset to market conditions?
2. An asset's history is valuable information. Users should do their own research on asset prices and token movements over time to get a feel for what might happen to the asset's value in the future.
3. What incentives are offered to provide liquidity? If they are significant, it can be worth the risk, but again, it pays for LPs to do their research before committing.

Another thing to consider is the role arbitrageurs play in the risk of impermanent loss.

What Role do Arbitrageurs Play in Impermanent Loss?

Arbitrageurs are nothing new; they have been plying their trade in external markets for a long time. In the crypto world, they operate in similar ways, simply with different assets. They also play a key role in impermanent loss.

Arbitrageurs take advantage of market inefficiencies to make a profit. In traditional markets, this means that they might buy an asset at a lower price on one exchange then quickly sell it on another for a higher price. They play an important role in smoothing out market inefficiencies and helping to keep the market stable.

However, their gains often come at the expense of liquidity providers when it comes to the crypto world.

This is because in their simplest form, automated market makers (AMMs) are not connected to external markets, whereas tokens can be. When a token price changes in an external market, an AMM doesn't automatically reflect the price change. Instead, it relies on an arbitrageur to buy the asset at a lower price or sell it at a higher price until the price offered by the AMM matches external market prices. For experienced traders, this can bring in a worthwhile profit.

But the profits extracted by arbitrageurs during this process doesn't come out of thin air. It has to come from somewhere, and inevitably, it comes from liquidity providers, leading to impermanent loss.

Keeping track of impermanent loss is crucial to maintaining a healthy portfolio, something Dexfolio has made easy. Users can quickly respond to market changes because they have fast access to real-time data.

Can Liquidity Providers Mitigate Impermanent Loss?

Savvy investors know how to mitigate impermanent loss most of the time by employing a few key strategies.

Choose stable assets in same-pegged pools

Some pools offer stablecoins such as USDC and DAI, which are pegged to the US dollar. This means that they always trade around the same value, resulting in low volatility and little to no impermanent loss. Liquidity providers can still earn fees but the risks are low. Other stable assets such as sETH are pegged to the large cryptocurrencies and are also low-risk.

Consider staking pools

Staking pools can be a good option as many only require one type of token instead of a balanced pair. Liquidity providers still earn a share of the transaction fees, but there is no impermanent loss as there is no need to balance the ratio of two assets.

Avoid highly volatile pools

Cryptocurrencies that are not pegged to the value of an external asset can be highly volatile, and liquidity pools that are subject to large fluctuations provide the biggest risk for impermanent loss. Highly volatile liquidity pools should be avoided if a user is unable to mitigate the risk.

Incentivized pools can offset the impermanent loss risk

Incentivized liquidity pools can offer rewards that offset the risk of impermanent loss. Liquidity mining programs are popular in the de fi space; participants are rewarded with governance tokens for providing liquidity. However, beyond the incentives of governance opportunities for early users, there is another advantage. Token rewards can far outweigh impermanent loss over time, making these types of liquidity pools an attractive proposition.

Dexfolio Makes it Easy to Track Impermanent Loss

While dealing with impermanent loss is often seen as an advanced or intermediate skill, beginners and experienced traders alike will benefit from Dexfolio's easy-to-use dashboard with fast access to trading data, helping to mitigate impermanent loss risks for those that do provide liquidity to the more volatile pools.