What is impermanent loss in DeFi?

Feb 28, 2021 | Community Guides

The world of decentralised finance is a weird and wonderful place. When we take people through it in our one-to-one sessions, we are constantly met with sceptical comments.

This is because when you look at some of the high APY liquidity pools and vaults you can put your coins in, their returns/interests are sometimes higher per day than your bank gives you per year.

Take Beefy Finance for example. Some of their high-interest vaults can get you over 1, 2 or even 3% A DAY.

What are liquidity pools in crypto?

When you put your coins in these pools you are providing liquidity. Hence, the liquidity pool.

So what that means in basic terms is, there is a requirement for a specific coin (or 2 coins) and the required platform i.e. pancake swap or another decentralised application.

Pancake swap (in this example) will then write a smart contract saying, if you provide these select tokens to our liquidity pool, in return we will give you a percentage of the transaction fees, from all the people that interact with these coins on our platform.

If the two coins/tokens you provide liquidity for are in high demand, this leads to more transaction fees and greater rewards paid to you in interest. Make sense?

Your bank does this in a way. It lets you deposit your money securely and in return, it lends ou all your cash and charges the people it lends it to. The only difference is that a bank pays you less than 1% a year…

Decentralised finance or DeFi, is removing the middleman and allows you to interact with the rest of the DeFi world and the middle(man) is a smart contract that doesn’t need to meet its quarterly target…

Why would you want to do this?

Well, if you have crypto sat in your wallet gathering dust, why not earn some interest on it? Simple.

Why do decentralised exchanges have liquidity pools?

Well, decentralised exchanges (DEX) like pancake swap, uni swap etc. set up these liquidity pools so that people using their DEX can trade directly with the pool. If Uniswap has an ETH/USDT LP then that has a large amount of ETH and USDT.

If someone wants to buy or trade USDT for ETH or visa versa, the liquidity pool can provide the ETH and UST to make this happen.

This gets away from the old order book model seen on CEX like Binance, AAX etc.

So what is the catch?

Well, there is and there isn’t one… The dreaded impermanent loss (IL) but to confuse you even more it doesn’t apply to all pools.

IL applies when you supply two coins/tokens to a liquidity pool and the value of one of those coins changes in relation to the other.

For example, if you provide liquidity to the BREW-BUSD vault on beefy.

  • $50 BUSD

  • $50 BREW

  • 50:50 ratio

  • Overall, the deposit is $100 in the BREW-BUSD LP token.

In this example, if BREW changes its value in relation to BUSD we may have a problem.

Example 1 – Bill decides to provide $100 worth of liquidity to the BREW-BUSD pool.

  • You have 10 BREW at $5 = $50

  • You have 50 BUSD at $1 = $50

The overall BREW-BUSD LP token is $100

Bob decides to just hold his BREW and BUSD in his wallet and not provide liquidity.

The price of BREW does up to $10 whilst BUSD being a stable coin remains the same.

If Bill now wants to remove his BREW-BUSD LP token the ratio of BREW: BUSD has changed.

He will have only 5 BREW and 50 BUSD, which is equivalent to the initial $100 he deposited. Make sense?

The ratio between the two coins changes based on the price.

Now, Bill has also been earning 3% compound interest a day on his deposit which over the course of a week, is now worth $122.99.

This is because each day his daily interest is reinvested automatically using Beefy Finance. Genius.

Although Bob has just held his BREW and BUSD and not provided liquidity, which is now worth $150.

Bill has effectively suffered a $27.01 impermanent loss. If he removes his LP token this is then permanent loss.

Bill can wat for the token price to come down or wait for the daily interest to catch up and overtake the impermanent loss.

Some things to be wary of when providing liquidity.

The more people that join the pool, the more people the LP rewards from transaction fees have to go around. This means the more popular the pool becomes the less daily and yearly interest you make.

You don’t suffer an impermanent loss on single deposit pools or stable coin LPs for that matter.

This is because IL is strictly dependant on the difference in price between the two coins you have provided.

If you provide two stablecoins, then their price is always near enough the same and hence you cant suffer a price differential.

So to build on that, what would happen if both coins you provided we non-stablecoins like CAKE-BNB? Exactly, you run the risk of both coins changing in price in either direction.

Now, the pools may reward you for depositing in these with higher APY. But it is completely your decision based on your risk/reward tolerance.

I (personally) prefer stable pools but if the daily APY can outrun any potential change in price between both coins then I’m also cool with that. After all, what is the point in being a DeFi degen if you cant have a bit of risk management?

In all seriousness DYOR and have a look at what suits you best.

There are a few cool tools you can check and monitor your IL and yield/profit generated from these pools.

Yield watch is a great website you can add your BSC wallet address and hit the binoculars. Now if you are using Beefy Finance, Pancake Swap, Jetfuel Finance, Auto and a few others, you can watch your yield and your IL by clicking the ‘i’.

You can head to yieldwatch.net HERE. We hope that helps!

SCAN THE QR CODE TO JOIN AAX TODAY!

OR click THIS LINK

AAX.jpg

Before you go…

Before you go, we have a Patreon page which is the price of a pint per month. It lets you know what we are buying and selling and when. It also has full access to my portfolio. You won’t get this access anywhere else.

You can join HERE

If you liked this article and want to learn more, we offer one-to-one support online to help you set up and get involved in the cryptocurrency space. Hit the ‘Book Today button’ at the top of this page to get started.

Alternatively, you can follow our group on Telegram for our side thoughts on the market. – @blocmates on Telegram.

Become a Patron!

0 Comments

Want access to our portfolio?Join our exclusive Patreon community for the price of a pint or cup of coffee

Our Patreon is home to our portfolio, what we are buying and what coins are soon to be released.

Exclusive content that you won’t get anywhere else is just the price of a cup of coffee or a pint a month.