Decentralized Exchanges (DEXs) use Automated Market Makers (AMM) to execute trades autonomously.
Here the user trades against liquidity pools, which are provided by liquidity Providers (LP). Liquidity pools are primarily in pairs e.g. ETH/USD.
Trading fees generated by the DEX incentivize liquidity providers
Providing liquidity for DEXs is a type of yield farming and some investors see it as more profitable than just buying and holding because LPs receive rewards from trading fees.
However, LPs lose money due to Impermanent Loss (IL).
What is Impermanent Loss?
This occurs when LPs deposit into a liquidity pool and the price of the tokens change.
The larger the change in price of the tokens compared to when they were deposited the larger the loss.
Luke is a liquidity provider who wishes to commit $200 to a liquidity pool that contains ETH/USDC pair.
This is a 50/50 pool which means that both tokens in the pair must be equivalent in value.
If 1 ETH is $100 and 1 USDC is $1 therefore 1 ETH is 100 USDC. Luke will commit his $200 to the pool by 1 ETH/ 100 USDC.
Now there is a total of 10 ETH/10,000 USDC in the pool deposited by other LPs Luke is therefore entitled to 10% of the liquidity pool.
After Luke commits his $200 the price of ETH rallied to $400 this creates a discrepancy in the price of ETH in the pool and the price of ETH in the market (other exchanges). As ETH in the pool is cheaper than ETH in the market.
This creates an arbitrage opportunity, arbitrage traders will add USDC to the pool to get ETH until the ratio reflects the current price of ETH.
Now the ratio between ETH/USDC in the pool has changed and there is now 5 BTC and 2,000 USDC in the pool.
If Luke withdrawal his 10% from the pool he will now get 0.5 BTC and 200 USDC both will give him $400
He made a profit right? Well if Luke had just simply used $100 to buy BTC and USDC and hodl he would have now had $500 in total.
So this difference of $100 is his impermanent loss the opportunity cost of him providing liquidity instead of holding.
Well technically the loss becomes permanent if Luke exits the pool but if he does not withdraw his deposit from the pool, there is a chance that the price of BTC will return back to 100 USDC hence why it is called impermanent loss.
So in other to not end up like Luke in this example and the other 50% of LPs who are losing funds here are ways to avoid and mitigate impermanent loss.
Provide Liquidity for Stablecoins
Remember in the example change in price (volatility) create arbitrage opportunity so it is wise to provide liquidity for stablecoin pairs where is hardly any price movement which reduces the risk of IL.
Provide liquidity for tokens that move hand-in-hand
One way to mitigate impermanent loss is by providing liquidity for tokens whose price action correlates i.e. they move the same way. This will make it hard for the changes in price to be taken advantage of by arbitragers.
Provide liquidity for one-sided pools
Some protocols like Bancor allow users to provide liquidity for one-sided pools, here a token is not paired with another and they earn fees for the LP for committing his token to the protocol.
But beware of the volatility of that token quick example:
If Luke commits 1 BTC to a protocol that offers a 10% reward in fees annually and 1 BTC is worth $100 all things being equal at the end of the year Luke will have 1.1 BTC worth $110.
But if the price of BTC falls to $50, Luke will still get his 10% reward which will amount to 1.1BTC but will only be worth $55 this is a loss.
Provide liquidity in pools that are not in a 50/50 ratio
Generally, liquidity pools offer a 50/50 ratio as they prioritize creating a balance pool and the chance of impermanent loss is higher with this ratio.
Some DEXs like Balancer allow Liquidity providers to commit their funds to different ratios like 80/20 or 70/30
This way the more volatile of the pair will be in a small ratio helping LP mitigate against IL.
Provide liquidity into reputable DEXs
Apart from impairment loss LPs can also lose funds to malicious actors who pose will pools will high returns also for liquidity providers only to get rug pulled as malicious developers drain the liquidity within the pool causing LP to lose their deposit.
The Bottom Line
All in all, when looking to provide liquidity you should be looking for tokens with low volatility in such a way that in the face of price changes, the trading fees paid to LPs will outweigh the impermanent loss and you will still be in profit.
[Editor’s Note: This article does not represent financial advice. Please do your own research before investing.]
Featured Image Credit: ChainDebrief
Author: Godwin Okhaifo