🌵What is Impermanent Loss?
Definition: Impermanent loss occurs when liquidity providers deposit assets into an automated market maker (AMM)/DEX (such as Uniswap, Balancer) liquidity pool, and due to large fluctuations in asset prices relative to the external market, the value upon withdrawal is lower than if they had "done nothing and held the assets separately."
🐟Reason: It happens during significant price fluctuations, where arbitrageurs frequently exploit the price difference between the pool and the market price, leading to the reallocation of your assets. For example, if ETH increases by 20%, the amount of ETH in the pool decreases, resulting in a lower total asset value than holding the assets separately when withdrawn.
Example🩷
If you deposit 1 ETH + 2000 DAI (with ETH priced at 2000 USD) into a Uniswap pool. Later, if ETH rises to 4000 USD, the amount of ETH in the pool decreases while DAI increases. When you proportionally withdraw the remaining assets, the total value in USD is actually less than holding 1 ETH + 2000 DAI separately, and this difference is the impermanent loss.
🧙♀Why is it called "Impermanent"?
Because as long as you do not withdraw the assets, this loss is "unrealized." If the market returns to the initial price, the loss will disappear. It only becomes an actual loss upon withdrawal.
What are the impacts? Can it be avoided?🐊
Impact: The greater the impermanent loss, the more volatile the market is likely to be. However, the trading fees earned by being a liquidity provider can partially or fully offset this loss.
🩵Avoidance methods (partially):
Choose asset pairs with low price volatility (such as stablecoin pairs) and some platforms (like Bancor) offer impermanent loss protection mechanisms, adopting dynamic fee rates and increasing rewards to compensate for losses.
Research and industry perspectives indicate that over half of Uniswap LP users experience actual returns that are lower than holding the assets directly (especially in bear markets). Impermanent loss is a common and structural risk in DeFi liquidity mining that cannot be ignored, and the industry is continuously innovating defenses against it.
💰🚩Conclusion: While earning trading fees as a liquidity provider, it is essential to be aware of the capital fluctuation risks posed by impermanent loss, especially when encountering significant price increases or decreases or when dealing with assets that are highly volatile. Strategic selection and risk control are extremely important.
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