Direct from the desk of Dane Williams.
A simple guide to what impermanent loss in crypto really is and how to manage it as an investor hunting high APRs.
Impermanent loss occurs when the value of assets in a liquidity pool changes while they are being held in a liquidity pool.
This can happen in decentralised finance (DeFi) when the market price of one of the assets in the pool changes significantly, while the other asset in the pool remains relatively stable.
This simple guide to impermanent loss in crypto offers a definition, an example, looks at when it’s desirable and more.
Let’s dive right in.
Example of impermanent loss
For example, let's say that you provide equal amounts of two assets, A and B, to a DeFi liquidity pool.
The current market price of A is $100 and the current market price of B is $200.
The total value of your assets in the pool is therefore $300 ($100 for asset A and $200 for asset B).
Now, imagine that the market price of asset A increases to $120, while the market price of asset B remains stable at $200.
The total value of your assets in the pool has now increased to $320 ($120 for asset A and $200 for asset B).
However, you have not actually realised this increase in value because you are still holding your assets in the pool.
If you were to remove your assets from the pool at this point, you would incur an impermanent loss.
This is because you would have to sell your asset A for $120, but you would only receive $100 for it when you initially added it to the pool.
The difference between the two amounts ($20 in this example) is the impermanent loss that you would incur.
When to accept impermanent loss
It's important to understand that impermanent loss is a risk that all liquidity providers in a DeFi liquidity pool face.
It's a result of the constantly changing prices of the assets in the pool and is an inherent risk of providing liquidity in a decentralised market.
But in saying that, there are times when accepting impermanent loss in DeFi is desirable.
Basically, this is when an investor treats the value of their LP position as a whole and not as two individual sides.
If that is the case, it's desirable to accept impermanent loss any time when your IL% < APR%.
That means happily accepting impermanent loss when your IL% is less than the APR% that you're earning on top.
When am I happy to accept impermanent loss?
When IL% < APR%.
Remember, I’m using LPs to stack more HIVE.
So with that being said, all I care about is being in profit overall.
I don’t care what happens to the value of each of my sides because they are always going to end up back into HIVE Power.
In my mind at least, it’s nothing more than HP earning me a higher yield.
That means that I’m happy to accept impermanent loss when my IL% is less than the APR% that I’m earning on top.
Example using my SWAP.HIVE:SPS LP position
You can’t be on Hive and escape the doom and gloom surrounding Splinterlands and in particular, the price of SPS.
In both USD and HIVE terms, the price of the game’s native token has been on a slide.
That means that in my LP position, I’m taking an impermanent loss which will see me ultimately end up with less SWAP.HIVE and more SPS.
As someone who is using this LP to stack HIVE, not something I want to see.
Should I care?
Well, having started with 2000 HIVE and 2000 HIVE worth of SPS on the other side, my position now looks like this:
That’s -378 HIVE
And +3000ish SPS, which is now only worth 278 HIVE.
But while that impermanent loss sucks on the surface, when you consider the APR I’ve been earning and cashing straight into SWAP.HIVE, you’ll quickly see that I certainly shouldn’t care.
At 60% APR, I’ve made 1782 SPS this month alone,
All cashed straight into HIVE as I go.
That means just this month, I’ve made 163 HIVE to make up for my impermanent loss shortfall.
Say I’ve been in the LP for 6 months and have earnt +977 HIVE in rewards.
977 minus the 378 I’ve given away to impermanent loss is +599 HIVE for 6 months on my LP position.
Comparing that to the +400 HIVE I could have earned by simply powering up my HIVE and curating at 10%, you can see that I’ve come out on top.
+200 HIVE better for the period!
Yes I've taken some liberties with my math, rounding up and not taking into account the fluctuating APRs and prices for simplicities sake.
But the sentiment remains the same - I come out ahead.
Benefits of LPs where one side is a stablecoin
The benefits of LPs where one side is a stablecoin are clear.
Put simply, having one side in a stablecoin effectively lowers your risk by cushioning you from volatile price drops.
They are especially effective if you believe the price of your other asset - the one that you want to stack more of overall - is going to fall in the short term.
What ends up happening here is you are DCAing into that asset from a stablecoin.
A liquidity pool with one side being a stablecoin also ensures you much more consistent rewards.
The reason for this is again that the stablecoin side of your position better absorbs downswings of your main token.
The result is a more predictable income in the form of rewards generated.
Now in saying that they dampen volatility to the downside and thus reducing risk, having a stablecoin side can be a double edged sword.
Just keep in mind that this dampening doesn’t discriminate between market direction and your ability to earn on upside movements will also be limited.
But as we’ve already gone over, this can be a small price to pay if the APRs are high enough.
Examples of LPs where one side is a stablecoin
As someone who is trying to stack more HIVE, the obvious example of LPs where one side is a stablecoin to use are:
- SWAP.HIVE:SWAP.BUSD on BeeSwap: Currently offering a 26% APR.
- bHIVE:bHBD LP on Cub Finance: Currently offering a 22% APR.
Both excellent choices with APRs much higher than the 10% you can get from curation rewards if you simply powered up that HIVE.
The Diesel Pool on Hive-Engine is incentivised by the BXT token, while the Cub Finance pool is obviously incentivised by the CUB token.
Both tokens generate revenue from their own Hive bridges that is then used to generate real value for their native token.
Meaning if you want to try this stablecoin LP strategy, you really can’t go wrong with whichever pool you choose.
Final thoughts on impermanent loss in crypto
I like the format of continuing to add related pieces of content into guides like this.
Bear with me.
No piece of content on my blog is wasted or sits in isolation.
See you around and as always...
Best of probabilities to you.