How to avoid impermanent loss and save money
Earning interest on your cryptos is great, but you're probably losing some of it to impermanent loss.
One of the most popular ways to make money in cryptocurrency right now isn't trading or investing. Instead it's by being a liquidity provider, which involves lending funds to DeFi platforms in return for interest, or "yield".
If you're providing liquidity like this on a decentralized exchange such as Uniswap, PancakeSwap or Curve you're currently exposed to the risk of impermanent loss (IL), whether you know it or not.
Impermanent loss is a unique risk for liquidity providers (LPs) who deposit funds in dual-asset pools.
It happens when your portfolio would have performed better if you'd just kept funds in your wallet, rather than depositing them into an LP position.
Given that the whole point for most people providing liquidity is to get a cut of trading fees and farm yield, it seems strange that this could actually end up costing us in the long run.
The problem happens because of the unique way Automated Market Makers (AMMs) work. Uniswap introduced the AMM model and it's now used by most modern decentralized exchanges.
Simply put, impermanent loss occurs because most pools are made up of two assets in a 50/50 ratio, based on the dollar value of those assets. Since the price of those two assets is constantly changing, the actual number of each token is constantly being rebalanced in order to ensure an even dollar amount of each asset.
This means that what you eventually withdraw won't be the same as what you originally deposited because you are entitled to a percentage of the pool, rather than a precise number of tokens.
For instance imagine you put 1 ETH and 100 USDC into an ETH:USDC pool.
Then the price of ETH goes up, while the price of USDC (a stablecoin) stays the same.
For the pool to stay balanced, the amount of USDC in it needs to increase to match the growing value of ETH.
This means everyone in the pool is now entitled to a bit more USDC, and a bit less ETH than they originally deposited.
So when you withdraw you get back a bit less 0.7 ETH and 100 USDC (plus trading fees).
In this scenario, your portfolio has grown, but not as much as it would have if you had just kept that 1 ETH and 100 DAI in your wallet.
An extremely simplified example of impermanent loss. Assets have grown in value, but less than they would have compared to just holding.
That example doesn't cover all the nuances, but it highlights why the issue matters. You can read our in-depth guide on impermanent loss if you want to get into the nitty-gritty details.
But if you simply want to avoid impermanent loss but still take advantage, here are some strategies to avoid impermanent loss while still enjoying the rewards of being a liquidity provider.
This article originally appeared in our cryptocurrency newsletter. Sign up below for weekly insights teaching you how to get the most out of your investment.
1. Same-peg asset pools
One of the easiest ways to avoid impermanent loss (IL) is to provide liquidity to a pool where both sides track the price of the same asset.
For instance Lido Staked Ether (stETH) is a token representing Ether (ETH) at a 1:1 ratio. That makes providing liquidity to a stETH:ETH pool a safe option as they both track the price of Ethereum (ETH).
Another would be a pool with two versions of wrapped Bitcoin, which are tokenized versions of Bitcoin that track the price of BTC. A popular option is the RenBTC pool on the Curve exchange, which is made up of renBTC and WBTC.
Curve is a highly popular AMM and actually has quite a few same-peg asset pools.
Provided both assets maintain their peg, then there is no risk of IL as the prices won't have diverged.
To help you find a pool, you can use a resource like Zapper.fi which lets you search for pools by token name.
You can then "zap in" to those pools using the interface, which makes for a super-smooth DeFi experience.
It's not without its quirks though, so check out our Zapper guide for more info.
3. Single-asset pools
This one is a bit of a cheat, as you actually have zero risk of impermanent loss when using single-asset pools.
So it's not so much a trick for avoiding IL, but rather a reminder that you don't need to provide liquidity to dual-asset pools if you don't want to.
You can just as easily get a return on your holdings from single-asset pools. On average returns are a bit lower as far as APY is concerned, but they are certainly nothing to sneeze at.
Some popular platforms with single asset pools include
- Yearn Finance
- Liquity
- PancakeSwap
Curve gets an honourable mention for its same-asset pools described above.
Then there is my favourite low-risk solution, which is lending coins via centralised finance or exchanges such as
3. Impermanent loss protection on Bancor
The latest version of the Bancor (v2.1) decentralized exchange has introduced the concept of "impermanent loss protection".
It essentially works by using an insurance fund to protect liquidity providers from impermanent loss once they have staked for 100 days or more.
When users withdraw, the fund compensates them for any losses due to IL.
If you withdraw ahead of the 100 day mark, you receive 1% for each day you were in the pool. So someone who staked for 40 days would get 40% of their IL covered.
The insurance fund is guaranteed by the protocol's "co-investments of BNT in pools" and in the event of the fund running short, Bancor will mint additional BNT tokens to cover the delta.
It will be interesting to see how this plays out for Bancor as the fund is yet to be stress tested in a significant market crash. Fortunately Bancor has a strong track record. I love the innovation and hope to see this become a feature of other AMMs.
3. Honourable mentions
If mitigating impermanent loss is the name of your game, rather than outright avoiding it, then there are a few more approaches you might want to consider.
Low volatility pools
Altcoins, especially shitcoins, are notoriously volatile. If you want to mitigate the risk of IL then choose assets which are historically less volatile than the rest of the market. Think of "blue chips" such as BTC, ETH and LINK.
Half-stablecoin pools
Impermanent loss is exacerbated by volatility in each of the two assets. If you choose a pool that uses a stablecoin as one half of the pair, then you are immediately eliminating one source of risk.
That being said, stablecoins do fluctuate, albeit in relatively minor ways. Also remember that not all stablecoins are created equal, and only those backed by actual US dollar reserves (such as USDC) can be expected to maintain their peg.
Personally I would advise against algorithmic stablecoins unless you have really done your homework.
Impermanent loss calculators
Lastly I want to point you in the direction of tools to help you better understand your risk of IL.
The Impermanent Loss Calculator from DailyDeFi is a trusted resource for myself and many others, which lets you project potential IL.
Impermanent loss is a great reminder that there's no such thing as a free lunch, especially in cryptocurrency.
Remember that the better the interest rates or APY on a given pool are, the more risk it is likely to carry. If there wasn't, everyone would already be farming it bringing the APY down to something more sensible.
Make sure to keep learning and do your own research before YOLO'ing your funds away in the ether.
This article originally appeared in our cryptocurrency newsletter. Sign up below for weekly insights teaching you how to get the most out of your investment.
Disclosure: The author owns a range of cryptocurrencies at the time of writing
