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Ask CryptoVantage: What is Impermanent Loss in Liquidity Pools?
With the explosion in Decentralized Finance comes new forms of risk for crypto users, one of these risks being something called Impermanent Loss. It is a term you may have come across already if you are using Liquidity Pools, but it is also something that is not necessarily told to users upfront when they are looking to add liquidity to a pool because it has a really high annual yield.
What is impermanent loss and how can It affect you? That is what we will answer in this edition of Ask CryptoVantage.
What is Impermanent Loss?
Impermanent loss is what happens when you provide liquidity to a liquidity pool, such as the ones on Uniswap or PancakeSwap, and the price of your deposited assets changes compared to when you deposited them. The bigger the value changes, the more you are exposed to impermanent loss. In this case, the loss means you will have less dollar value at the time of withdrawal than at the time of deposit.
How Can it Affect Me?
If you deposit an asset into a liquidity pool and the value of the asset goes up, the pool automatically adjusts ratios of each asset in the pair as their prices change, resulting in a different amount when you withdraw your share.
This means that you lose value because if you held the asset in your wallet, the value simply rises and you have profit, but if it is deposited in a liquidity pool and the value of the asset goes up, it has to adjust for the price increase or your pair is no longer even and then when you go to withdraw your share you have less than if you had held it in your wallet.
Why Would I Provide Liquidity Then?
Well for the returns mostly, if your liquidity pool is providing enough of a return it will mitigate your loss because you are simply making up the lost amount in the form of rewards. You can then convert them into whatever asset you lost if you wish.
Paper vs Real Loss
It is worth keeping in mind that while you may look at your liquidity pair and see that you have lost X amount of an asset, it is only a loss on paper, it is not realized until you remove the liquidity and becomes a real loss. So, it may be advantageous to not panic if you see the prices of assets you are providing liquidity for changing and just hold on to your position to keep reaping whatever rewards you are receiving.
