Understanding Impermanent Loss
Impermanent loss can arise when there is a price discrepancy between a trader’s assets on a DEX, usually a cryptocurrency, and a stablecoin (such as USDC).
When the cryptocurrency price falls relative to the stablecoin, the trader can experience a loss due to the price difference.
This is known as impermanent loss.
How Impermanent Loss Works
Impermanent loss occurs when traders use a DEX to buy one asset with another asset.
Let’s imagine that a provider needs to offer equal levels of liquidity in both USDC and ETH, but suddenly, the price of ETH goes up.
This creates an opportunity for arbitrage because the price of ETH in the liquidity pool now doesn’t reflect the market price.
Other traders will buy ETH at a discounted rate until the equilibrium is restored.
After arbitrage, a liquidity provider may have a greater amount of UDSC and slightly less ETH.
Impairment loss is the difference between the trader’s new portfolio balance and what they would have had if they had just held on to their old balance.
The loss is realized when a trader withdraws the liquidity from the pool.
Methods to Mitigate Impermanent Loss
One way to prevent impermanent loss is to use stablecoins, such as USDC and DAI, or wrapped versions of the same assets, like wBTC offered by Curve.
Balancer also offers arbitrary weights for its liquidity pools, different from the 50/50 model, which can reduce the risk of impermanent loss if a token has a higher weight.
Impermanent loss can also be minimized by setting up a portfolio of assets that are relatively well-correlated.
This way, when the prices of the assets diverge, the portfolio will remain relatively balanced, and the trader can avoid any unexpected losses.