Risks in Yield Farming: Impermanent Loss Explained

In Yield farming, investors earn rewards by providing liquidity to various pools, but it has risks, one of which is impermanent loss.

Yield farming has rapidly gained popularity in the decentralized finance (DeFi) space as a means to earn passive income. 

This article delves into yield farming and the concept of impermanent loss, its causes, and how investors can mitigate its impact.

Understanding Yield Farming

Yield Farming refers to leveraging capital within DeFi protocols to generate returns through interest, trading fees, or governance tokens. 

Simply put, it is staking or lending crypto assets to generate high returns or rewards in additional cryptocurrency. 

This investment strategy involves participants, known as liquidity providers (LPs), who add their assets to liquidity pools.

At its core, Yield Farming provides liquidity to decentralized exchanges (DEXs) or liquidity pools in exchange for rewards. 

These rewards often come in the form of additional tokens issued by the protocol, offering participants an opportunity to earn passive income on their crypto assets.

Key Components of Yield Farming

Yield farming involves users participating in DeFi projects and lending their cryptocurrencies via smart contracts to earn additional tokens as rewards. Here are the key components of yield farming:

• Liquidity Provision
• Yield Optimization
• Governance Participation

Liquidity Provision

Yield Farmers contribute digital assets to liquidity pools, enabling efficient trading within decentralized exchanges. By supplying liquidity, participants earn a portion of the trading fees generated by the platform.   

Yield Optimization

Yield Farmers often employ sophisticated strategies to maximize their returns, such as yield aggregation platforms and automated market maker (AMM) strategies. These techniques help optimize capital allocation and mitigate risks associated with impermanent loss.

Governance Participation

Many DeFi protocols distribute governance tokens to liquidity providers, granting them voting rights over platform upgrades and decision-making processes. Yield Farmers can actively engage in governance activities to influence the future development of decentralized platforms.

Benefits of Yield Farming

Yield farming in decentralized finance (DeFi) offers several potential benefits for users who are willing to participate:

• High Yield Opportunities
• Diversification of Income Streams
• Access to Emerging Projects

High Yield Opportunities

Yield Farming offers the potential for significantly higher returns compared to traditional savings accounts or conventional investment vehicles. With annual percentage yields (APYs) often exceeding triple digits, Yield Farming presents an attractive proposition for investors seeking alpha in the crypto market.

Diversification of Income Streams

By simultaneously participating in multiple DeFi protocols, Yield Farmers can diversify their income streams and hedge against market volatility. Diversification reduces the risk of capital concentration in a single asset or platform, enhancing the resilience of investment portfolios.

Access to Emerging Projects

Yield Farming provides early access to new DeFi projects and tokens, allowing participants to capitalize on the growth potential of innovative blockchain ventures. Early adopters often enjoy preferential rewards and incentives, fostering community and collaboration within the DeFi ecosystem.

Risks in Yield Farming

Yield farming has emerged as a preferred option due to its potential to offer higher returns compared to traditional investments. 

Yet, before you get started, it’s crucial to understand the hidden currents that churn beneath the glittering surface of high returns. 

While the potential to outpace traditional investments is undeniably tempting, Yield Farming carries a price tag far heavier than mere gas fees. 

Some of the potential risks associated with yield farming include:

• Smart contract bugs
• Impermanent loss
• High gas fees
• Market volatility
• Governance risks

Smart contract bugs

Yield Farming relies on smart contracts, which are pieces of code that execute certain functions automatically and without human intervention. However, smart contracts are not immune to errors, bugs, or malicious attacks, which can result in the loss or theft of users’ funds.

Impermanent loss

Impermanent loss is a term that describes the loss of value that occurs when users provide liquidity to a pool that involves two different tokens, and the price of those tokens changes relative to each other.

High gas fees

Gas fees are the costs that users have to pay to execute transactions on the Ethereum network, which is the most popular platform for DeFi and Yield Farming. 

However, gas fees can vary significantly depending on the network congestion and demand, and they can sometimes spike to very high levels, making Yield Farming unprofitable or even impossible for some users.

Market volatility

Market volatility is the degree of variation in the price of crypto assets, which can affect the profitability and risk of Yield Farming. 

Crypto markets are known to be highly volatile, as they can experience sudden and drastic changes in price due to various factors, such as news, events, regulations, sentiment, supply and demand, and speculation.

By doing so, investors can mitigate potential liquidity risks and safeguard their financial interests, ensuring a more secure and informed approach to navigating the world of DeFi development.

Impermanent Loss Explained

Impermanent loss occurs when the price of a token rises or falls after you deposit it in a liquidity pool. It indicates a loss when the dollar value of your token at the time of withdrawal is less than the amount deposited. 

Impermanent loss is a temporary loss associated with the volatility of the trading pairs that LPs place in AMM-based liquidity pools. This indicator is expressed in dollars and shows how much the liquidity provider has lost in terms of the funds actually withdrawn, as compared with the value of the assets if they had simply been stored in a crypto wallet.

The AMM balances the ratio of crypto assets in the pool at 50:50, thereby setting their value.

AMMs use the following formula as the pricing mechanism:

X * Y = K

where X and Y are a pair of assets in the pool, and K is a constant that must be the same before and after the transaction.

The main reason for impermanent loss is the discrepancy between the value of the coins in the pool and their real market price.

Factors Influencing Impermanent Loss

• Price Volatility: Higher volatility between the assets in the pool increases the potential for impermanent loss. Significant price movements lead to greater imbalances, resulting in larger losses.
• Duration of Liquidity Provision: The longer assets remain in the pool, the greater the risk of price fluctuations, increasing the likelihood of impermanent loss.
• Pool Composition: Pools with assets that are less correlated or have greater price discrepancies are more susceptible to impermanent loss.

How Impermanent Loss Occurs

To understand impermanent loss, consider a liquidity pool with two assets, such as ETH and USDT, in equal value. Suppose an LP deposits 1 ETH (worth $2,000) and 2,000 USDT into the pool. The total value of the deposit is $4,000.

If the price of ETH increases to $3,000, the pool’s algorithm adjusts the ratio of ETH to USDT to maintain balance. This adjustment leads to a situation where the LP now has fewer ETH and more USDT. If the LP withdraws their funds, they might receive 0.866 ETH and 2,598 USDT, which totals $4,596.

While the LP has made a profit, this amount is less than the $5,000 they would have had by holding the assets outside the pool (1 ETH worth $3,000 and 2,000 USDT). The difference between $5,000 and $4,596 ($404) is the impermanent loss. 

How to Avoid Impermanent Loss

While impermanent loss cannot be entirely avoided, several strategies can help mitigate its impact:

• Try Stablecoin Pairs
• Invest a Portion of Your Assets
• Avoid Volatile Pairs
• Invest in uneven liquidity pools
• Try Liquidity Mining
• Invest in New Liquidity Pools

Try Stablecoin Pairs

The first thing you need to understand is that volatility is the deciding factor impacting the size of the impermanent loss. 

The more the value of an asset changes, the greater the loss. Therefore, one way to reduce the risk of its occurrence is to work with crypto assets with a lower volatility.

If you provide liquidity to a pair such as USDT/USDC, you will not be exposed to any risk of temporary loss because the prices, as the name implies, are stable. It is an effective strategy in a declining market because you will still profit from your share of trading fees.

Invest a Portion of Your Assets

Another way to reduce your exposure to impermanent loss is to split your crypto assets in half. Only one portion should be invested in a liquidity pool. 

Then, hold the other half to cut your potential impermanent loss by two. Since only half of your assets are invested in the pool, fees and benefits are cut in half. 

Consider the ETH/DAI pair. If the price of ETH rises by 50%, you will incur a 2.02% temporary loss. 

If you invested $1,000, you would incur an impermanent loss of about $20. However, if you only invest half of your ETH/DAI pairing into the liquidity pool, your impermanent loss is reduced to US$10.1.

Avoid Volatile Pairs

Avoiding more volatile cryptocurrency pairs can help you avoid temporary loss. If your research suggests that one asset in a pair exceeds the other, you should look for more stable pairs. 

You should also look for LPs with asset ratios that differ from the standard 50/50 split. For example, Balancer has flexible pools with asset ratios like 95/5, 80/20, and 60/40. Do the math and discover what works best for you.

Invest in Uneven Liquidity Pools

Uneven LPs can help minimize impermanent loss because a significant price movement for a specific asset has less damage and covers less than half of the asset’s value. 

Finally, even if you risk temporary loss, some liquidity pools provide incentives to cancel any possible losses from a price change. If the trading fees are high, your share of the costs may surpass any temporary loss.

Try Liquidity Mining

Liquidity mining is another popular DeFi investment strategy. It rewards the liquidity provider with a native token in exchange for providing liquidity. 

Invest in New Liquidity Pools

Putting your assets in pools that have recently opened can provide a certain level of protection. You’ll get a larger share of the pool and a higher reward through commissions for providing liquidity, which can partially or completely cover the impermanent loss.

You can also invest in pools with high commissions and APY (annual percentage yield), which can also help reduce impermanent loss.

It goes without saying that you should also track the prices of coins and tokens that you have invested in liquidity pools so you can withdraw your crypto assets in good time.

Conclusion

The concept of liquidity pool impermanent loss is crucial in decentralized finance, especially yield farming. Understanding the meaning of impermanent loss will show you how much profit you miss out on by becoming a liquidity provider instead of simply holding your assets. 

Yield farming is a relatively new area of decentralized finance, so it’s critical to understand the risks involved. DeFi prediction markets and decentralized exchanges are also popular DeFi protocols with risks and strategies.

Despite the risk of impermanent loss, you can still determine whether a particular liquidity pool is profitable. If your yield returns are more significant than your impermanent loss, you will have higher returns than simply holding your assets. Consider the fees you can charge as a liquidity provider.