Beginners Guide to reduce the risk of impermanent loss in liquidity mining and staking

by | Dec 26, 2021 | DeFi Resources

This blog will be way more beneficial to all those mainstreamers and institutional users and help them reduce the risk of impermanent loss. Liquidity. In short, this blog will help to meditate on any loss from Impermanent loss. If I tell you, Impermanent loss meaning, it is a risk that people unaware of it accidentally or consciously stumble into it. That risk is when a user provides liquidity to AMMS, and AMMS can see their stalked token loose value compared to simply holding the tickets on their own.

The impermanent loss meaning could be put as a difference between holding tokens in anAutomated Market Maker and holding them in your pocketbook.

What is an Automated Market Maker (AMM)?

AMM stands for Automated Market Maker, and it is a system that provides liquidity to the exchange it operates in through automated trading.

Before their invention in the early 1990s, orders book were used in place ofAutomated Market Maker. These books had to be manually populated by humans who were likely to make manual initiation trades to enhance the market’s liquidity. 

Why anAutomated Market Maker (AMM)?

The approach of making manual initiation trades on order books wasn’t that much convincing as it was the reason for some slippage and latency in price discovery on the market. Furthermore, 

As mentioned earlier, Some users are unaware of it, and most of the users are vaguely familiar with it; that’s why I had written that blog for you. And now I would like you to dive further into it so that you know its bits and bites and can help yourself not get trapped in that!

With the invention of AMM-based decentralized exchanges, the usual order book is substituted by liquidity pools that are pre-funded on-chain for both assets of the selling couple, and the liquidity is provided by other users who also earn passive income on their deposit through trading fees based on the percentage of the liquidity pool that they provide.

The usual order book is replaced by liquidity pools that are pre-funded on-chain for both assets of the selling couple, and the liquidity is provided by other users who also earn passive income on their deposit through trading fees based on the percentage of the liquidity pool that they provide, thanks to the invention of AMM-based decentralized exchanges.

An Intensive talk about Impermanent Loss:

When does Impermanent Loss occur?

It occurs when for some reason, the price of tokens in AMM deviates in any direction rather than staying in a steady-state or in uni-direction.

Why could Impermanent loss happen?

You’ve to be way more cautious with that than with Impermanent loss because as long as the relative prices of tokens return to their original state, the loss disappears, and you earn 100% of the trading fees. 

Nevertheless, this is infrequently the case as mentioned above that you will earn 100% of the trading fees even relative prices of tokens return to their original state.  

Knowing why Impermanent loss is essential is crucial to understand how it could happen to know why and how this could happen at the back of your mind and how to get rid of it.

How Does Impermanent Loss Occur?

To fully understand how Impermanent loss occurs, we should first realize how AMM works and its role as arbitrageurs.

A brief about how AMM works

AMMS, by default or in their raw form, are disconnected from external markets. If token prices change in external markets for some reason, theAutomated Market Maker usually doesn’t automatically adjust its prices. Why doesn’t AMM update the change in token price right away? It requires arbitrageur to come adjacent and get the underpriced asset or trade the overpriced asset until prices given by theAutomated Market Maker match external sales. 

While this process mentioned above is operating, the outcome profit derived by arbitrageurs is adequately eliminated from the pockets of liquidity providers, resulting in the impermanent loss.

Let me break it down into simple wordings by telling you an example.

For example: suppose an AMM with two assets, ETH and DAI, set at a 50/50 ratio. A change in the price of ETH opens a chance for arbitrageurs to profit at the expense of liquidity providers.

Automated Market Maker Impermanent Loss Price Function reduce the risk of impermanent loss

Alright, as you’ve in the above graph by examing different prices movements, you can see that even a minor change in the price of ETH cause liquidity providers to suffer impermanent loss. 

Considering the above process in context, this is an issue that needs to be addressed! In such a case, the AMM is to achieve widespread adoption among everyday users and institutions. 

Suppose the users have to regularly check and react to the change in the AMM to avoid their significant losses. In that case, liquidity provision becomes a game reserved for only the most advanced traders.  Another possible solution to such loss could be designing second-layer tools to monitor and manage AMM risks; why not in the first place lessen impermanent loss at the protocol level.

Which protocol can help us in that regard?

Bancor Protocol version 2.1 offers a brand new way of meditating and provides complete protection to liquidity providers from impermanent loss. In that way, users can earn passively yield without overwhelming fear of their stacked assets losing value.

Now we shall discuss some of the strategies that could help you in meditating impermanent loss.

Strategies that may help meditate Impermanent Loss.

By now, I believe you know about Impermanent Loss (IL). It’s the best time to let you know about the strategies that help mediate IL. 

Avoid unstable liquidity pools:

Crypto assets, unlike stablecoins, are not tethered to the value of external support. Therefore their value changes according to market demand.

Take notice that the largest sources of IL risk are liquidity pools based around volatile assets. While crypto blue-chips like ETH and WBTC are volatile, far smaller coins, have a considerably higher probability of experiencing significant intraday price changes, making them far riskier in terms of temporary loss.

If avoiding temporary loss is your goal, staying away from unpredictable liquidity pools could be a good decision.

That’s one of the strategies from a bunch of it. I would encourage you to look at some of the ways and strategies to meditate on impermanent loss. You can read about it from here.

Conclusion

AMMs are significantly more robust and economical for generating decentralized liquidity because of the benefits of risk-minimized liquidity provision and single-token exposure.

Autowhale is not a financial advisor or financial service provider. Any opinion expressed are for informational purposes only. Find more content at autowhale.net/blog

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