What is Decentralized Finance (DeFi)? pt. 4 | Impermanent Loss
What is the risk of yield farming or providing liquidity between 2 tokens to earn yield?
Impermanent Loss
This is the 4rd issue of "What is Decentralized Finance (DeFi)?". If you missed the first 3, check them out below. This series will also be indexed under my master index of educational crypto content (at some point) - "Learn Crypto Stuff".
The idea with this series is to educate people that are new to cryptocurrency or new to DeFi on how it works. Decentralized finance can definitely be intimidating if you've never done anything with cryptocurrency before aside from just holding or trading it. Another reason that people can find it intimidating, or confusing, is that it does require a little bit of technical know-how to get started.
Have no fear though, NiftyPhill is here to help you learn the ways of the financial system of the future! I also need to preface this by saying I am not an exert nor am I a financial advisor. I'm a guy that has been playing with cryptocurrency since 2015 and has done a ton of different things with it so I'm speaking purely from experience.
If you've never heard the term impermanent loss, you probably have never done any yield farming. In that case, I'll direct you again to the first 3 parts of this series above. If you're just now learning about decentralized finance, it's important to understand some of the risks that come with it. When you're totally in charge of your assets and have the ability to do literally whatever you want with them, it's your responsibility to understand exactly what you're doing.
When explaining what impermanent loss is, I like to imagine one of the old school scales like you see above. When you add tokens to a liquidity position, you have to add an equal dollar amount of both tokens. For example, if you're adding $1000 to the pHIVE-POLYCUB pool on PolyCUB, you would add $500 worth of pHIVE and $500 worth of POLYCUB. Obviously the actual amount of each token depends on what the price is at the time of adding liquidity.
What you have to take into account is... Both POLYCUB and pHIVE are crypto tokens that are both subject to volatility. When the prices of tokens in liquidity positions fluctuate, the liquidity position is automatically balanced. This is where impermanent loss comes in, because the liquidity position must remain a 50/50 ratio and that can result in an unrealized loss or gain based on the price of both tokens.
It's a lot easier to understand with a visual example, so if we take $1000 and enter the pHIVE-POLYCUB pool it will look something like the screenshot above from SushiSwap. Because the price of both of those tokens fluctuate, the underlying algorithm is keeping those tokens at a 50/50 ratio in the background by adjusting the amount of each.
I hate math, and don't think I should try to explain how it's calculated because I'd probably butcher it. So instead, we will use the impermanent loss calculator here to get an idea of what this looks like. It calculates the impermanent loss for you and compares it to if you had just held the 2 tokens.
In the example, I took the price of POLYCUB for Token A and the price of pHIVE for token B. When you added your $1000 worth of liquidity to the pool, the price of POLYCUB was 20 cents and the price of pHIVE was 56 cents. The price of POLYCUB went up to 25 cents and the price of pHIVE went down to 49 cents. Now you have an impermanent loss of 1.57%.
Your liquidity position is now $1045, but would have been $1062 if you had just held the tokens. When you remove the liquidity position, you will receive less POLYCUB and more pHIVE based on the price fluctuation. Let's consider if the price of both tokens went up instead since you never know which way the market is going to go.
If the price of POLYCUB went to 30 cents and the price of pHIVE went to 60 cents, you would have an impermanent loss of 1.4%. In this case, you would get back 2112 POLYCUB and 1056 pHIVE. You would have 1.4% less value than if you had just held the 2 tokens.
Hopefully this is making sense. If it is, you might be wondering "Why the hell would I want to subject my assets to losses when I could just hold the tokens?". Very fair question. Here's why - the yield can easily outweigh that loss. Right now that particular pools is offering over 300% APY. So is 1.4% loss too much for you to handle when you're going to yield over 300% APY?
This is why we yield farm instead of just holding the tokens. There's nothing wrong with being a die-hard holder but you have the ability to earn a lot more passive income if you can handle the risk. The more volatile the assets in the liquidity pool, the more risk there is. There's even pools of only stablecoins like the pHBD-USDC pool for those that want to minimized impermanent loss. You can still earn over 30% APY by providing liquidity to this stablecoin pool.
This is the financial system of the future. It's time to wake up and take advantage of being in on the ground floor. We're building something that could literally change the way people use their money on a daily basis. We're building something that could replace banks. Something that could free the world from debt slavery. We are building the future and I'm glad to be a part of it.
Go forth and conquer, frens.
Post written by: @l337m45732 aka NiftyPhill.
Posted Using LeoFinance Beta
