What is Impermanent Loss in Uniswap?
If you are familiar with the term DeFi, there are chances you have come across terms like Uniswap and impermanent loss. The former is a coveted decentralized cryptocurrency exchange platform that revolves around the Ethereum blockchain. The latter, on the other hand, is a term that is thrown around a lot with it.
This kind of loss occurs when your token price changes as compared to the time when you deposited them in the crypto pool. Typically, the larger this change is, the greater the amount of impermanent loss. In case you want to know about “what is impermanent loss” in Uniswap, you are in the right place. Let us tell you all about it.
Read this to learn all about What is DeFi Kingdoms?
What is Uniswap?
Before we move on to questions like – “What is impermanent loss in Uniswap,” let us first learn about what Uniswap is. As stated in the intro, it is an Ethereum blockchain-based decentralized crypto exchange platform. Unlike centralized exchanges like Binance and Coinbase, what makes Uniswap different is that it is a fully decentralized platform.
It means that when it comes to ownership and operations, this is not done by a single entity in the platform’s case. Instead, it makes use of the relatively latest trading model. In case you are not aware, it is known as an automated liquidity protocol. The platform, further, came into existence in 2018, and as already stated, is built on top of the Ethereum blockchain.
Many of you may know that the Ethereum blockchain is at the top when it comes to market capitalization. If you go by the statistics, it is the second-largest cryptocurrency project all across the globe. Due to this, it is compatible with every ERC-20 token, and numerous wallet services like MyEtherWallet, MetaMask, etc.
The platform is further simple to operate. Anyone using it can copy the code, and thereby come up with decentralized exchanges. It means that this exchange is completely open-source. Along with this, the users can also list tokens on the exchange service for free. This feature differentiates Uniswap from other normal centralized exchanges.
The latter are usually profit-driven. It means that if you list new coins using them, you will have to pay a very high fee. Now, since Uniswap is a completely decentralized exchange (DEX), there is another thing you need to know. The users using it get to maintain control of all their funds at all times. So, you do not have to completely give up control of your private keys.
This feature of the platform makes it less time-consuming and inexpensive when compared to normal centralized exchanges. Also, since you are retaining control of your private keys, there is no risk of losing assets, especially if the exchange gets hacked someday. The platform today has nearly billions worth of crypto assets locked on its protocol (nearly $3).
Also, it ranks the fourth-largest when it comes to decentralized finance (DeFi) platforms. With this, we hope you have a little input on what Uniswap is. After familiarisation with the exchange platform, it is crucial to know about the other term in the picture before we get to Uniswap impermanent loss. Let us find out what impermanent loss is. Keep reading!
What is Impermanent Loss in Uniswap?
Before we tell you about impermanent loss, do you know what the liquidity pool is? In simple words, it is a crowdsourced pool that has cryptocurrencies or tokens that are sealed in a smart contract. This pool facilitates trades between the assets of crypto owners and therefore is quite crucial when it comes to trading on a decentralized exchange (DEX).
Now, coming to impermanent loss, this is something that happens when you give liquidity to a liquidity pool, and there is a change in asset price. It means that when compared to the price of assets when you deposited them, the price is different at withdrawal. As also stated in the intro, the bigger this price change, the more the impermanent loss that you are going to experience.
To make it easier for you, this means that at the time of withdrawal your assets will have less dollar value while it was higher at the time of deposit. So, in case you are wondering if it is possible to lose money with impermanent loss, you may not have to lose money for this kind of loss to occur. Let us learn more about Uniswap impermanent loss.
When it comes to Uniswap impermanent loss, the pools that contain your asset are important. For instance, those that have assets that remain in a relatively small price range are known to be not as exposed to an impermanent loss for liquidity providers. A great example of these is different wrapped coins or stable coins. These, typically, are at a smaller risk of impermanent loss.
Why Do Liquidity Providers Provide Liquidity Despite the Risk of Impermanent Loss?
Now, many of you may wonder why LPs (liquidity providers) still provide liquidity? After all, by doing so, they are getting exposed to potential losses. Well, there is a sane explanation for this. If you are familiar with trading, you may be aware of this. For those who are not, trading fees can still counteract impermanent loss. Yes, you read that right.
By paying trading fees, liquidity providers can easily prevent impermanent loss. With this, even when it comes to those pools on Uniswap that are super exposed to impermanent loss, traders can earn profit. This fee is 0.3% on every trade. Thus, if a pool has a high trading volume, it can turn out to be profitable despite the impermanent loss.
That being said, various other factors play a role in deciding this profit and loss. These range from the wider market conditions and the specific pool to deposited assets and pool protocols. Now, let us get into Uniswap impermanent loss a bit more in detail. For it, you need to know how this loss happens. Let us find out.
How Can Uniswap Impermanent Loss Take Place?
To explain this to you, here is an example that will show you what impermanent loss looks like to a liquidity provider. Let us say that liquidity provider Ben deposits 1 ETH and 100 DAI. In this liquidity pool, the deposited token pair needs to be of equivalent value. If we go by this, at the time of deposit, the price of ETH is 100 DAI.
It also shows that Ben’s assets’ dollar value at the time of deposit is 200 USD. Along with this, the liquidity pool has 10 ETH and 1,000 DAI that are funded by other liquidity providers. It means that when it comes to the share of the pool, Ben has 10%. Also, his total liquidity is 10,000. Now, assume that the price of the ETH goes up to 400 DAI.
Now, while this price increase happens, the arbitrage traders will try to benefit from it. They will add DAI to the pool and remove ETH from it. This is until the ratio of the pool reaches the current price. Now, since the ratio between assets determines their price, this is what will happen. While the total pool liquidity (10,000) will remain the same, the assets ratio changes.
As per the changes, the pool now has 5 ETH and 2,000 DAI. Now, what if Ben decides to withdraw his funds? Here is what happens – we know that he has a 10% share of the pool. So, when he withdraws, he gets 0.5 ETH and 200 DAI. These have a dollar value of 400 USD. Certainly, he made a profit of 200 USD here. However, what if he decides to hold his 1 ETH and 100 DAI? What happens then?
Well, in that case, the dollar value of these holdings when combined would be equal to 500 USD. This means that it would have been better for Ben to hold the ETH and DAI rather than depositing them into the pool. And this loss that Ben experienced here is “an impermanent loss.” While here the loss Ben had was not that large due to the deposit being small, impermanent loss can sometimes be huge.
That being said, there is another thing you ought to know. Ben’s example here does not include the trading fees that he could earn for providing liquidity. Thus, in numerous cases, this fee would make up for the losses due to impermanent loss. It, therefore, makes providing liquidity by traders profitable irrespective of impermanent loss.
Despite this fact, before you decide to provide liquidity to a DeFi protocol, make sure you understand what this loss is. Now that you understand how Uniswap impermanent loss happens, let us move on to our next question – Is impermanent loss good or bad? Here is what you need to know in regards to it.
Is Impermanent Loss Good or Bad?
When it comes to impermanent loss, the name is misleading. You can only know about this loss once you withdraw your coins from the liquidity pool. It means that once you do so, the loss you experience is very much permanent. Sure, the trading fee may cover the loss you experience. However, in no way, that the loss impermanent.
So, depending upon your situation, the loss can be good or bad for you. Always keep this in mind and be super careful when you decide to deposit funds in an AMM. After all, not all liquidity pools are exposed to the same amount of impermanent loss. For some, it may be less while for others, it may amplify.
When depositing in liquidity pools, follow this simple rule. Typically, if the pool is more volatile, it is likely to be exposed to impermanent loss. The best way to learn is by starting with a small amount. Doing so will give you a rough estimation of the expected returns. Once you find it out, you can commit to a more significant deposit amount.
Another thing that you can keep in mind is looking for tried and tested AMMs. Also, it is a great idea to stay away from pools that promise unusually high returns. Chances are, they may have a trade-off somewhere, and may result in a greater loss for you. After all, when it comes to AMMs, they are easy to fork and make small changes with.
What is the Secret to Staying on The Top?
Now you know whether an impermanent loss is good or bad, and things to keep in mind about it, let us tell you how to stay on top and completely avoid it. The only answer to it is – Vigilance. That’s right, you need to be alert and observe everything.
Always keep in mind that to earn more, the risk is something you have to take, especially if you are looking to make the most out of your cryptocurrency. To put it simply, you can go safe and slow. Stablecoins are perfect for it. Alternatively, you can come up with an extensive strategy that can help you upsurge the risk threshold.
You also need to educate yourself and have in-depth knowledge of trading crypto, and numerous other things about it. Once you do so, it will be easy to consider your options and know if going slow is right for you or if it is best to be fast and aggressive. Nonetheless, both these options can turn out beneficial for you if you know to use them the right way.
We hope, by now you have the answer to – What is Uniswap impermanent loss? To conclude, we can only say that when it comes to the DeFi space, everything can be quite confusing just like the term impermanent loss. Therefore, always make sure to understand things completely. You also need to always be watchful of the crypto trends to stay ahead and be safe on your DeFi adventure. Good luck!