Guide

A Complete Guide on Impermanent Loss

Introduction

The cryptocurrency market has allowed investors to find a new avenue for generating profits with DeFi. DeFi is the short-term for Decentralized Finance which stands for the type of cryptocurrencies and blockchain projects that can keep working without the need for any centralized supervision like banks or financial agencies. Some DEX or decentralized exchanges have gained considerable traction among cryptocurrency investors.

What is Impermanent Loss?

The decentralized finance investment platforms do not have state agencies or private financial institutions managing them. These DeFi projects and DEXs can keep operating automatically with the use of computer programs such as smart contracts and DAOs. Furthermore, these DeFi platforms are also decentralized and it means that they do not have any type of funds or reserves to back them up.

Since these DeFi platforms are owned by the community, it means that the contributors of the platform have the option to offer funds that can work as a reserve or liquidity. It means that the users who own certain digital currencies that are listed on the DEXs or swaps can commit them for a specified period. Impermanent loss or IL is the loss that occurs when the value of the committed tokens drops from purchase cost after adding to a liquidity pool.

How does Impermanent Loss Work?

Impermanent Loss occurs when the price of a cryptocurrency that has been added to a liquidity pool or an AMM project is devalued. The Impermanent loss is the deficit of digital assets that is the calculated difference between the price of pledged cryptocurrencies between withdrawals and deposits. The investors need to note that the IL only converts into a real or incurred expense when a withdrawal is made. It means that as long as the said cryptocurrencies with a price decline remain committed in the AMM or Liql.uidity pool it is still not a realized loss. Investors can choose to keep their pledges and minimize or completely reverse their losses.

What is Investment Loss?

There are several different types of investment avenues for investors such as stocks, commodities, and bonds among others. When it comes to investing the traders also have to learn and deal with different types of investment losses. Depending on various factors, investors can deal with the classification of losses when investing:

Direct Participation Program

A direct Participation Program or DPP is a type of investment that allows the investors to gain access to the cash flow of a business and get tax-related perks. DPPs are usually legal financial programs. However, in some cases, investors on the upper level can use DPPs as a way to siphon funds and demand huge commission fees from investors. DPPs require long-term investment commitments and they are typically illiquid. Therefore, the investors do not have the option to dissolve their positions when they want. In many cases, investors can suffer from 5-10 year DPP related losses.

Margin Abuse

Margin Trading is a type of investment that is conducted with borrowed money. The investors who are using margin trading need to be very careful and should have extensive experience. Margin traders have a dedicated account where they store their investment funds as collateral.

However, Margin traders need to ensure that the value of their investment assets does not fall below their borrowed amount to prevent a margin call. The lenders can pressure the investor to maintain the value in their margin account at all times. Margin trading can lead to extensive losses for investors if they are inexperienced or dealing with highly volatile investment products.

Ponzi Scheme

A Ponzi scheme is a type of financial scam that depends on speculation and marketing techniques rather than the utility of the underlying asset. A Ponzi scheme requires investors to earn money by introducing new investors. However, there is no point where the business is generating income. Therefore, eventually, new investors stop joining the trap and the whole program collapses resulting in massive losses.

Promissory Note

A Promissory note is a type of IOU that startups issue in place of a security or stock to collect funds. Promissory notes do not grant ownership rights to the investors like stocks or securities. However, Promissory notes come with a promise of a share in the profits that a company can generate using the loaned funds. However, PNs are also a way for unlicensed brokers or those who have lost their security license to collect funds from the investors. In many cases, investors who put their money into Promissory Notes end up with losses.

Selling of Business

Selling of business is a type of illegal investment practice where a registered broker invites an investor to a great opportunity. However, the investment is made outside the accounting records of the firm. It means that the record regarding such investments is not recorded in the books of the registered firm. According to FINCEN regulations, it is a violation of the law and results in losses in addition to dire legal consequences for investors.

What is a Liquidity Pool?

While reading about Impermanent Losses, the reader detected the term liquidity pool several times. It is natural to ask what is a liquidity pool and why should a DeFi Investor learn about it. The answer is that liquidity pools are an important method of generating income from cryptocurrencies. A liquidity pool is a collection of pledged funds in a decentralized exchange platform or a swap that allows the investors to exchange funds readily. Liquidity pools are based on two types of digital assets also called a trading pair.

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For example, a trading pair can contain two cryptocurrencies such as ETH and DAI. The ratio of the pool is kept at 50% for both currencies. It is also correct to assume that the trading pair is a cryptocurrency reserve that is operated using smart contracts. The investors on the platform can easily exchange one type of cryptocurrency for another using tokens present in the liquidity pool.

What are Automated Market Makers?

Automated Market Makers or AMMs are the programs that are present in decentralized exchanges or swaps for automation of liquidity pools. The AMMs ensure that the ratio of a liquidity pool is maintained and they also allow the investors to create and approve cryptocurrency exchanges without the need for any centralized verification authority. AMMs also ensure that the uneven changes in the token prices are adjusted in real-time to ensure the correct value of cryptocurrency exchanges. In many cases, the value of a given cryptocurrency can also vary on account of its ratio or concentration in a liquidity pool.

How to Calculate Impermanent Loss?

It is not enough to know the definition and working of impermanent loss. A cryptocurrency investor who wishes to use liquidity pools for investing should also be able to calculate the IL beforehand. It is important to note that in any liquidity pool, the ratios of the trading pairs have a big impact on the price estimation of said currency. In the same manner, the number of liquidity pool contributors can also make a huge difference in IL.

Investors can also find automatic calculators that allow them to weigh the IL projections using the initial and future book value of the pledged cryptocurrencies. In the same manner, some IL calculators automatically report and fill the cryptocurrency dominance in a trading pair and the deposit amount in a given pool. Some liquidity pools contain only Stablecoins. Since Stablecoins have a stable price projection, it is easier to maintain them in comparison to a volatile digital currency-based liquidity pool.

Risks Related to Liquidity Offering

When it comes to liquidity pools, cryptocurrency investors can create a passive income stream easily. Imagine an investor who purchased around 5 Bitcoins. The same investor then put his Bitcoin purchases in a liquidity pool for 6 weeks. During this time, the investor would not be able to use his 5 Bitcoins for anything else. However, they will keep earning the liquidity reward from the DEX or swap. After 6 weeks, when the investor takes out their Bitcoins from the liquidity pool. Their earnings are going to consist of capital gains generated from Bitcoin price appreciation in the main market in addition to the liquidity rewards.

Therefore, many investors wish to find the best swaps or liquidity pools to maximize their earnings. However, it is important to note some of the most common financial risks that are related to liquidity pool investing.  There is a common idea among a greater population of the cryptocurrency community that liquidity pools are detrimental to DeFi platforms that can give rise to impermanent losses. As long as the trading pair currencies are pledged in a liquidity pool, the investors cannot estimate the losses about their book value. Additionally, many investors believe that IL is going to occur eventually.

It means that the price of the trading pair cryptocurrencies is going to drop at one point or another. However, some can counter the statement by claiming that there are good chances for the trading pair cryptocurrencies to regain their lost value and even print additional losses. However, in some cases, cryptocurrency investors do not have the choice to take out their trading pair before the specified term is completed. Additionally, investors can also have an error in price projections on account of unforeseen circumstances or sudden changes in market dynamics.

How to Avoid Impermanent Losses?

Even when there are risks related to liquidity pool contribution, it does not mean that the investors should miss out on the opportunity to earn some extra profits. Losses in cryptocurrency investment are part of the deal and the investors who have done their research and spent some time learning about the related dynamics and inner workings of the sector are in a better position to avoid losses. In the same vein, here are some methods that will allow the investors to minimize or avoid ILs:

Low Volatility

The liquidity pools that consist of highly volatile cryptocurrencies are at risk of generating ILs more frequently. Therefore, investors have the option to commit to the liquidity pools that are present in the form of stablecoins. Since stablecoins are cryptocurrencies with a uniform price evaluation, the investors can’t experience ILs unless the peg is broken. In the same manner, low-volatility cryptocurrencies are also better options for liquidity pool pledges.

One-sided Liquidity Pools

Typically, cryptocurrency liquidity pools require the investors to commit two types of digital currencies in a liquidity pool that is also called a trading pair. Meanwhile, there are some cryptocurrency platforms like Bancor that allow the investors to stake in a liquidity pool with only one type of cryptocurrency. When the investors have pledged only one type of cryptocurrency in the pool their chances of experiencing an IL are sliced in half. Furthermore, Bancor allows the liquidity network to expand using integration from oracle facilitated by Chainlink. It means that the major price changes are automatically adjusted for pool stakers unlike liquidity pools with trading pairs.

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Trading Fees

The investors who are using a liquidity pool also have to pay trading fees. The trading fee in question is used to reward the liquidity providers. The income generated from trading fee rewards is enough to offset or mitigate the IL. Therefore, the number of users in a liquidity pool also matters while calculating projections. If there are more users, it means that the stakers are going to earn more trading fees rewards.

Complex Liquidity Pools

Complex Liquidity Pools are the innovative decentralized pools that enable different ratios of cryptocurrencies rather than a 50:50 trading pair dominance. The Balancer is a good example of a complex liquidity pool. It means that are some trading pairs on Balancer with an 80:20 or even 98:02 ratio and the investors do not have to experience ILs as long as the ratio is maintained depending on the popularity of the cryptocurrencies in a trading pair.

Pledge Duration

Pledge Duration can make all the changes for the liquidity pool. It is important to note that a pool contributor does not experience loss until they withdraw or dissolve their trading pair. It means that by opting for a longer duration of pledging, the pool contributors can convert their ILs into profits by the changed price dynamics for the cryptocurrencies in question.

Recoverable Losses in Investment

There are some cases where cryptocurrency investors can also learn about some types of losses that allow them to recover. It is not possible to dodge every type of loss when it comes to trading. Despite all the preparation and projections, the market is an independent enterprise that keeps changing and shifting and it is affected by several factors. The investors cannot control the market dynamics even if they are the large holder or they have extensive experience. However, there are some cases where the investors can reclaim their losses that are mentioned as:

Unauthorized Trading

Unauthorized trading is the prospect of getting scammed by a broker who does not have proper registration or verification. It is important to mention that the brokers are investment consultants who should have a security license from the respective financial regulators in their region.  Without the registration, the broker does not have the authority to offer investment advice or run an investment vehicle.

Therefore, unless the power of attorney from the investor has been granted to an unlicensed broker, the investors can apply for recovery of losses that are generated as the result of their unsolicited advice or portfolio management. In some cases, brokers who end up losing their registration also come under the umbrella of unauthorized traders. Investors can contact investment organizations, financial regulators, and law enforcement agencies to reverse their losses.

Churning

Churning is a phenomenon where a broker is conducting excessive financial transactions using a client investment to generate inflated commission fees. Churning can occur with brokers who have discretionary authority over an investment account. It means that they can move the funds into an investment portfolio without needing approval from their clients or financial firm. Churning can even generate such an artificially inflation commission expense that can shrink the profits for the clients. Clients can perform a financial audit to detect churning and report it to related authorities for demanding a loss recovery.

Tax Deductible

Investors not only make use of their profits but also their losses. It means that the investors can apply for a tax-deductible on account of the losses that they have experienced from an investment venture such as pool staking. However, it is important to note that unrealized losses are not subject to tax benefits and investors cannot apply for a tax deduction based on them.

Conclusion

When it comes to investing within or outside of the DeFi sector, it is best to treat losses as a part of the process as much as profits. When an investor ignores losses, they can become overly enthusiastic and forget about taking the necessary precaution and prevention techniques to avoid them. For the same reason, DeFi pool contributors need to learn about Impermanent Losses.


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Hassan Mehmood (Saudi Arabia)

Hassan is currently working as a news reporter for Tokenhell. He is a professional content writer with 2 years of experience. He has a degree in journalism.

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