DeFi (decentralized finance) not only creates new investment opportunities for cryptocurrency holders, but also brings unique challenges. For example, if you deposit digital funds in the DeFi liquidity pool, you may worry about "impermanent losses". So what is the impermanent loss? First of all, you should understand what a liquidity pool is?
A liquidity pool is an automated program in which users deposit cryptocurrencies in exchange for the costs incurred by others when they use their liquidity to trade or borrow. If you have an encrypted wallet, you can add funds to the liquidity pool and collect token rewards. You often find liquidity pools in DeFi applications such as dex and decentralized loan platforms. The people who deposit tokens in the liquidity pool are often referred to as "liquidity providers" or "income farmers".
The funds deposited in the liquidity pool are open to DeFi dealers and investors. For example, the liquidity pool on DEX Uniswap allows people to conduct untrusted point-to-point token swaps. The liquidity pool on the DeFi lending website allows users to borrow passwords by depositing digital collateral.
The liquidity pool does not rely on centralized brokers or banks, but uses coded smart contracts to execute instructions. When the conditions of the smart contract are met, it will automatically execute its programming response. The algorithm run by the liquidity pool on dex ensures a specific relationship between the two token prices. For example, Uniswap uses the following formula:
X * y=k -- where "k" is a constant, and "x" and "y" refer to the value of the two cryptocurrencies in the pool.
Although the liquidity pool needs to maintain a constant value, the encryption price is never constant. As the price of digital assets in the liquidity pool rises or falls, traders take advantage of this trend by buying or selling tokens from DEX. This trading practice is called "arbitrage", which helps to naturally correct the supply of tokens in the liquidity pool.
This is where the impermanent loss enters the picture.
As traders change the supply of tokens in the liquidity pool, the liquidity provider's token share will change relative to its initial deposit. Even if the dollar value of deposits rises, liquidity providers will earn more if they hold tokens due to the increase of tokens. You can calculate the non permanent loss in crypto by subtracting the current market value of their initial deposit and the dollar value of their token share in the liquidity pool.
For example, suppose you initially deposit 1 Ether (ETH) and 2000 USDC, but your current shares in the liquidity pool are 0.816 Ether and 2449 USDC. In this case, you must multiply today's ETH market value by 1 and 0.816, add the relevant USDC value, and then subtract the difference.
Suppose that in the above example, the price of ETH rises to $3000, and your liquidity pool will suffer a non permanent loss of $103. Here are the detailed steps for how to get this number:
1. If you hold your initial investment, the value is: (1 ETH x 3000 USD)+2000 USDC=5000 USD
2. Current value of liquidity pool: (0.816 ETH x 3000 USD)+2449 USDC=4897 USD
3. Difference between the two: USD 5000 - USD 4897=USD 103
Only when the liquidity provider decides to withdraw its token will the contingent losses become permanent losses. It is always possible to readjust the price of encryption to a level closer to your initial investment. Keep in mind that liquidity providers will continue to receive token rewards on their platforms, while the percentage of crypto rewards collected by farmers per unit yield may offset volatile losses.
