Impermanent Loss Phenomenon

Impermanent Loss Phenomenon: An Easy Guide About The DeFi Space

DeFi or decentralized finance offers various hazards to investors. The impermanent loss phenomenon is a  prominent issue when dealing with the evolving market. This article will explore the implications of an impermanent loss liquidity pool. Along with that, this article will also talk about how to calculate the variation and decrease the risk of this phenomenon. We will also discuss the impact of impermanent loss when price goes down.  There are many who wonder what is impermanent loss yield farming, you will find the answer in the course of this article. 

Holding The Notion Of Impermanent Loss Phenomenon

There is a high chance of impermanent loss in every given scenario. A net difference in the value of two tokens in a liquidity pool creates an impermanent loss. Imagine a scenario where:

  • An investor contributes liquidity to a liquidity pool. 
  • The relative worth of the accumulated asset fluctuates at the time of the deposit in relation to its primary value. 

In an investing function, the higher the value changes, the greater the ability for a trader to lose. Irrespective of the direction of the value, it is important to remember that impermanent losses might happen. An instance may help you better evaluate this topic, as we will illustrate in the dedicated section.

An Easy-to-Read Instance Of Impermanent Loss Phenomenon

As is often the scenario, a practical instance can help us evaluate better how a seemingly complicated notion operates. The impermanent loss phenomenon can be convenient to evaluate when the value of a token falls. However, the ideal idea may not be instinctive in a bull market case.

For this purpose, we will target the most famous digital currency: Bitcoin, and anticipate a bull market scenario in this instance. Suppose any liquidity provider employs 10 BTC in a liquidity pool. For ease, let us anticipate that the liquidity pool has 50 percent BTC and 50 percent USDT. In this instance, to avoid useless overcomplications, we can anticipate an ideal parity between USDT and the US Dollar.  If we take $20,000 as the value of one Bitcoin, we have the following scenario:

  • Amount of Bitcoin to contribute: 10.
  • Amount of USDT to contribute: 200,000 (i.e.20,000 times 10).

Let us anticipate that this liquidity pool has a complete asset value of 50 BTC and 1 million USDT. In other terms, we are stating that this liquidity provider holds a 20 percent share in the pool.

Suppose the value of Bitcoin doubles, hitting $40,000. Instinctively, anyone holding BTC will be happy about this, but what occurs in this example?

Here comes the tricky section. The liquidity provider will presently have 10 BTC and 400,000 USDT. Note that the price of the pool would also double. Accordingly, the liquidity provider would still hold a 20 percent share of the pool.

At this point, we are required to compute two crucial values:

  • BTC liquidity is basically the square root of the complete initial value of the pool funds divided by the Bitcoin price. Accordingly, we have 50 Bitcoins multiplied by 1 million USDT, divided by 40,000. The square root of this value is 35.36.
  • Token liquidity on the other hand is the square root of the total initial price of the pool funds increased by the value of Bitcoin. Consequently, we have 50 Bitcoin multiplied by 1 million USDT, expanded by 40,000. The square root of this value is 1,414,213.56

Suppose that the liquidity provider selects to withdraw the assets presently. He would receive 20 percent of the available Bitcoin liquidity (i.e., 35.36). We would be speaking about 7.07 BTC.

With respect to USDT, a similar reasoning would bring us to a withdrawal of 282,842.71 Tether. What if the liquidity provider selects to easily keep the assets in a different wallet instead of joining a pool? This measurement is much more convenient, as the liquidity provider would presently have 10 Bitcoin times 40,000 USDT plus 400,000 USDT. In other terms, the liquidity provider would keep 800,000 USDT.

In our instance, the impermanent loss phenomenon is the variation between 800,000 USDT and 282,842.71 USDT. Instinctively, the bigger the change in a token value, the more prominent the impermanent loss will be.

Final Words

There is no chance an investor would ever wish to face a loss that is both costly and irreversible. This fallacy is a problem for investors who aim to employ the blockchain to take benefit of the crypto space.

Our guide offered the readers a theoretical interpretation of what an impermanent loss phenomenon is. More crucially, we aimed at a realistic instance in which a liquidity provider may register an impermanent loss. Finally, we shared some common wisdom on decreasing the risk of falling into this common decentralized finance trap. There are also many impermanent loss calculators that you can use for this purpose.

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