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Updated April 18, 2023
Liquidity pools were a game changer in the world of decentralized finance (DeFi). Providing liquidity to an Automated Market Maker (AMM) is a great way to generate passive income by earning a share of the trading fees generated by the AMM. However, as with any investment, there are risks and temporary losses are one of them. In this blog post, we explain what transient loss is, what causes it, and how you can mitigate it.
What is temporary loss?
A temporary loss is the temporary decrease in value suffered by liquidity providers when providing liquidity to an AMM. This loss occurs because the price of the two tokens in the liquidity pool can change over time, resulting in a temporary drop in value for the liquidity provider.
What Causes Impermanent Loss?
The reason impermanent loss occurs is because the price of the two tokens in the liquidity pool can change over time. Typically, one token increases in value relative to the other, resulting in liquidity providers ending up with fewer tokens of the accreting asset and more tokens of the declining asset. This leads to a temporary loss of value for the liquidity provider.
How to mitigate temporary losses?
One way is to provide liquidity for pairs where price volatility is relatively low, reducing the risk of large price swings. This way you can reduce the chances of a temporary loss.
It is important to remember that temporary loss is temporary loss of value. If you keep your LP tokens long enough, the price of the two tokens in the pool will eventually converge and your loss will be recouped. Additionally, the trading fees earned by the AMM can help offset some of the temporary loss.
Liquidity pools with low temporary loss
The BNBx BNB pool on @ThenaFi_ is an excellent example of a low volatile loss liquidity pool. This is because the relative change in value between BNBx and BNB is very small. This pool currently gives 19% APR and already has around $7 million in liquidity.
Diploma
In summary, fickle loss is a risk that all liquidity providers in DeFi need to be aware of. It is important that you do your own research and never invest more than you can afford to lose. Providing liquidity to pairs with low volatility can help mitigate the risk of a temporary loss. If you take the necessary precautions, liquidity pools can still be a great way to generate passive income in the world of decentralized finance.
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