A temporary loss occurs when the algorithmically determined formula of automated market makers (AMM) in DeFi reveals a discrepancy between the price of an asset inside and outside a liquidity pool. The AMM eliminates middlemen on decentralized exchanges and trades assets from a liquidity pool of tokens provided by liquidity providers.
A constant algorithm formula maintains the liquidity pool by balancing the ratio of tokens to pool size. Due to the AMM calculator’s emphasis on the ratio, the depreciation results in a loss for assets outside the pool.
What is Impermanent Loss?
The temporary loss is the gap between your value and the value of the assets you put into a liquidity pool instead of holding your crypto assets. You have a fickle loss when the value would have been higher if you simply kept your crypto in your wallet instead of supporting liquidity.
A temporary loss therefore equals an opportunity cost. The difference between a temporary loss and an unrealized loss on a stock investment is that your original investment in the liquidity pool is not included in the calculation, unlike an unrealized loss. Instead, the value of your investment in the liquidity pool is compared to the value you would have had if you had simply kept your tokens based on the mix of tokens still in circulation.
Because of the way the term ‘impermanent loss’ is calculated, it is conceivable to have both a temporary loss and an unrealized gain. The fundamental problem that can lead to fickle losses is that the amount of tokens in the pool changes when swaps happen.
A temporary loss can occur due to a number of factors.
- Volatile Tokens: A temporary loss is more common when one of the tokens in a trading pair is more volatile than the other.
- New or little traded tokens: New or little traded tokens may not have adequate pricing or a market large enough to entice arbitrage traders.
- Wide trading range: A temporary loss can also occur if you allow a larger trading range. Some decentralized exchanges, like Uniswap, allow you to fine-tune the trading range for tokens.
- Small tanks: Token prices are more easily pushed around in small liquidity pools.
How to calculate temporary loss
A temporary loss occurs when tokens in a liquidity pool are compared to their holding value. Token pairs in the fund should have equal aggregate values. To get an equal total, the formula X*Y=K is used. The calculator requires the value of one token to match the value of another token in the pool. The basic principle of the automated pricing model is the equivalency ratio.
Source: CoinGecko
If a trader wants to trade A for B in a liquidity pool with 50% token A and 50% token B, the number of tokens A will decrease while the amount of token B will increase. To get the value of the two tokens, the AMM algorithm would increase the price of token A relative to token B. The larger the gap between the tokens, the higher the temporary loss.
The temporary loss of AMM liquidity pools with similar assets has been greatly minimized. Calculating volatile losses becomes more complicated with a larger number of liquidity providers. Liquidity tools in DeFi include DeFiPulse, vFat, DeFiLlama, and LiquidityFolio. DeFi Pulse and DeFiLlama are statistical tracking methods and vFat is a yield farming calculator. LiquidityFolio is a liquidity management solution for Uniswap investments.
Volatile Loss in Crypto
The temporary loss in crypto is practically as big as in the stock market. DeFi service providers can mitigate fickle losses by using staking rewards to buffer liquidity providers. The strategy pays liquidity providers a percentage of the platform’s trading fees.
To make up for the loss, the protocols reward the LPs with the platform’s native tokens, which derive their value from network activity. Liquidity providers earn more in distributed fees and token rewards as volatility rises and trading activity increases.
Uniswap, a liquidity pool, created an incentive scheme based on project-based tokens. Tokens can be exchanged or used in different parts of the DeFi system. Liquidity delivered to the relevant balancer may result in token gains. Timing is key in providing liquidity as users who provide liquidity during high trading activity seasons will see higher returns than users who provide liquidity during low activity seasons.
Strategies to mitigate fickle losses
Using stablecoin pairs
Stablecoin pairs like USDC and USDT can be used to avoid temporary losses. Stablecoins are not prone to volatility and the risk of temporary losses is significantly reduced. In doing so, a trader can earn trading commissions. The disadvantage of providing liquidity with stablecoins is that there are no gains in a positive market. A temporary loss is inevitable even in moments of strong price fluctuations.
trading fees
Trading fees can be used to cover temporary losses. All DeFi transactions incur trading fees, part of which are shared with liquidity providers. Trading fee revenue could be enough to offset short-term losses. The temporary loss decreases as the number of charges received increases.
volatility
Currency pairs used to provide liquidity is one element that can help minimize temporary losses. Liquidity pairs are very volatile with each other. Volatile losses would increase as one token in a pair outperforms the other.
LP ratio
Some DeFi protocols have a 50/50 AMM ratio. As the pool strives to even out its value, the ratio increases the aspect of temporary loss. Other decentralized exchanges may have different ratios, and exchanges may allow multiple assets to be merged.
price variance
Stablecoins could shield DeFi systems with a single-currency pool of liquidity from volatility that can lead to larger temporary losses. To avoid temporary losses, a trader should wait for a pair’s price to recover to the original entry level. Some AMMs may only have one currency liquidity pool instead of two.
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