Cryptocurrency Markets’s prices move faster than Traditional Markets. It is very important for cryptocurrency investors to be aware of the possible risks involved in the market before starting their investments. Impermanent loss is the one of possible risks that traders take on in the cryptocurrency markets. Similarly to traditional financial markets, cryptocurrency markets have lots of financial derivatives that traders could earn revenue. Let's examine together in which situations the impermanent loss, which traders of Decentralized Finance (DeFi) platforms are familiar with occurs.
Decentralized Finance – DeFi platforms, which are a big part of the crypto money ecosystem, offer the opportunity to trade between various crypto assets in a decentralized way. Unlike centralized exchanges, DeFi platforms which do not use order boards, offer the necessary liquidity to match users using liquidity reserves (or liquidity pools). The providers of this liquidity, on the other hand, receive a share of the transaction fees paid by the traders in proportion to the amounts they lock into the pools. Impermanent loss occurs when asset prices change compared to when they are invested in liquidity pools. Although an impermanent loss is called a temporary loss, it does not fully meet its meaning, because the loss does not occur before the assets are withdrawn from the liquidity pool. However, the loss will become permanent once the assets are withdrawn from the liquidity pool.
In practical terms, the impermanent loss is the net difference between the value of two cryptocurrencies in an automated market maker based on a liquidity pool.
So why and under what conditions do liquidity providers take this risk?
The main motivation of being a liquidity provider in Decentralized Exchanges - Dex is to earn revenue. The fact that the risk of impermanent loss can be taken for liquidity providers is that sometimes this loss can be compensated with the return. Experienced liquidity providers prefer pools of assets with less volatility compared to other crypto assets to reduce this risk ratio. Thus, it will be ensured that income is obtained from assets whose price difference is less variable compared to the time when the liquidity investment is made and that there is no impermanent loss or reduction.
DeFi platforms use a system called the Automated Market Maker that allows its users to deposit their assets into a liquidity pool. Liquidity pools contain a pair of assets, the asset pair is usually Ethereum-based and a stablecoin like DAI. Users who want to exchange between these pairs of assets can exchange assets for the transaction price offered by the platform. As a result of this transaction, the transaction fee will be paid to the people who deposit money into the pool, which are the liquidity providers.
