The DeFi craze of 2020 introduced the world to a new and interesting way to earn passive income through liquidity mining and other forms of yield farming. If you haven’t yet jumped into DeFi staking, you may not be aware of some of the risks associated with a liquidity pool (LP). In addition to the usual risks of token staking (price dumps, rug pulls, APY taking a dive, etc.) you’ll be taking on an additional category of risk known as impermanent loss.
What Is Impermanent Loss?
As multiple tokens are required to provide liquidity, an overall loss can occur if any token loses value. This is known as impermanent loss because it is only realized if funds are withdrawn while the token prices are lower. Yet it no longer affects you if token prices were to rebound.
Providing liquidity requires staking equal values of different tokens, which generates an LP token. This new LP token is then staked in a new pool to earn a yield. By way of example, if I stake $100 of an imaginary token named XYZ along with $100 of ETH that will generate a new LP token which I can then stake for a higher yield through the XYZ project or on another farming site.
This represents compensation for taking on additional risks. Staking tokens, in other words, is equivalent to locking them away for some time.
You are paid for this action because you renounce your ability to sell the tokens and exit the investment. This impacts the market price as you effectively remove part of the token supply from circulation during this time. Growing the LP against which others can execute live trades signals to the world that the community is willing to commit to supporting the token for an extended period.
On popular platforms such as Uniswap or Balancer, the value of any pair of tokens in a liquidity pool must remain equal. This means that if XYZ drops in value, the pool will automatically convert ETH to XYZ to keep them equal.
Uniswap and Balancer use different algorithms for their automated market-making (AMM). While they’re both categorized as a constant function market maker (CFMM), Uniswap is classified as a constant product market maker and Balancer is classified as a constant mean market maker.
Avoiding Impermanent Loss
As with anything in the financial world, profits are never guaranteed. The only way to ensure that $200 remains $200 when you pull it out is to withdraw your original tokens when they’re at the same price they were when you deposited them. Tracking the initial prices of your tokens when you began LP staking can help you avoid losses.
So what if XYZ goes to zero. Whenever a token price in a balanced liquidity pool is zero, no tokens will be available to withdraw as all token prices will be balanced to zero.
Concluding, when staking in any DeFi protocol, you should expect a fair amount of impermanent loss will happen. As it is extremely hard to avoid it completely, make sure the yield is high enough to account for all of the risks.
