What is Impermanent Loss in DeFi?

Impermanent loss is a type of risk that is inherent in decentralized finance (DeFi) protocols. In automated market maker (AMM) systems, impermanent loss is the loss that a market maker incurs when the price of the asset they are providing liquidity for moves against them. This loss is temporary and will be reversed as soon as the price of the asset moves back in the market maker’s favor.

This type of loss is often compared to the risk of liquidation in traditional financial systems. However, there are important differences between the two. First, in DeFi protocols there is no central authority that can impose liquidation rules. This means that lenders and traders must rely on automated mechanisms to protect themselves from loss. Second, because DeFi protocols are built on blockchains, they are subject to the volatility of cryptocurrency prices. This makes impermanent loss a unique and potentially significant risk DeFi.

AMM and Impermanent Loss

Automated market maker systems in DeFi are designed to provide liquidity to markets by constantly buying and selling assets in order to maintain a consistent price. However, these systems, as mentioned earlier, can also be subject to impermanent loss, which occurs when the price of an asset fluctuates and the market maker is unable to sell the asset at a price that covers the cost of buying it. This can happen when the market maker is unable to buy the asset back at the same price it sold it for, or when the market maker buys an asset at a high price and the price subsequently falls.

Impermanent loss is a risk that market makers must take into account when setting prices and managing their inventory. It is important to note that, while impermanent loss can be a significant problem for market makers, it is not always a bad thing. In fact, impermanent loss can actually be beneficial to market makers, as it provides an incentive for them to constantly monitor the market and adjust their prices accordingly.

Overall, automated market maker systems can be a great way to provide liquidity to markets. However, market makers need to be aware of the risks of impermanent loss and take steps to mitigate it.

How to Reduce Impermanent Loss in DeFi?

The best way to eliminate impermanent loss in DeFi is to use a smart contract that can automatically adjust its supply in response to changes in the underlying collateral asset price. This way, the smart contract will always hold enough of the collateral asset to cover the value of the debt, and there will be no need for a liquidation mechanism.

Another way to eliminate impermanent loss is to use a collateral asset that is not subject to price volatility. This could be a stablecoin that is pegged to a fiat currency such as the USD or Euro.

Finally, you can also reduce your exposure to impermanent loss by diversifying your portfolio of collateral assets on an exchange or protocol that charges low fees. This way, even if one asset experiences price volatility, your overall portfolio will be more stable.