Entering the market to generate some passive income from your digital assets, you are probably aware of yield farming and liquidity providing. Today, some DeFi protocols, like Uniswap, SushiSwap, and PancakeSwap, allow users to act as liquidity providers by depositing their digital assets in liquidity pools.
This is a relatively easy way to make money, but you need to know the risks, so here we will consider what it is, how it works, and how to avoid impermanent loss.
Liquidity describes how easily an asset can be bought or sold, based on supply from buyers and demand from sellers, without causing a major change in its price.
Liquidity pools are built on smart contracts and are set up to manage funds (cryptocurrencies) deposited into them. These funds are supplied by liquidity providers and they get rewarded in exchange.
Liquidity Providers (LP) contribute two tokens (e.g., ETH and USDC) to pools. The pool relies on an automated market maker (AMM) algorithm (similar to the one in Uniswap) to determine what price should be charged, based on the ratio of the tokens. Traders can interchange tokens right in the pool. LPs get some of the trading fees from the pool.
Liquidity pool impermanent loss occurs when the prices of tokens in a pool differ from their initial price at the time of deposit. Here’s how it works.
When you add liquidity to a pool, you are essentially depositing two (or more) tokens in equal value. As traders exchange the tokens in the pool, that ratio is adjusted to reflect market prices.
If the value of the assets differs too much in terms of the amount of one token compared to the other, the pool automatically rebalances the amounts of tokens. When you later pull out your share of the pool, you get out a different mix of tokens than you originally put in.
When there is a higher price change, your share of the pool becomes worth less than if you’d just held the tokens outside of the pool. That difference in value is called impermanent loss.
To calculate impermanent loss you can use a simple formula that works off the price ratio between the assets in the pool:
Where:
r = new price ratio (price of asset after change/price of asset at deposit)
This equation offers a rapid method for the estimation of impermanent loss according to the magnitude of the price change.
Here's the impermanent loss explained in a particular example.
For instance, you’re adding liquidity to a pool with two tokens: ETH and USDC, in a 50/50 proportion. At the time of deposit, 1 ETH = $1,000 and you give 1 ETH and 1,000 USDC (worth $2,000).
The situation is as follows: let’s say the ETH price has doubled and now costs $2000, and USDC costs $1. To keep your share as 50/50 the pool rebalances it to the new price: half the value is in ETH ($1,000) and half is in USDC ($1,000). $1,000 / $2,000 = 0.5 ETH. Therefore, you are left with 0.5 ETH and 1,000 USDC (to keep your original equivalent of $2000).
Now compare that to simply holding the assets: 1 ETH is now worth $2,000, and 1,000 USDC is still $1,000. So, the total value is $3,000.
Thus, by providing liquidity you have $2,000 in total (0.5 ETH * $2,000 + $1,000 USDC), and in the case of just holding the assets, you’d have $3,000.
So, in this impermanent loss example the total reduction of your capital is $1,000.
Liquidity providers face unavoidable risks, but there are possible ways of impermanent loss mitigation. By following these impermanent loss strategies, you can make better decisions, and perhaps beat the average returns.
To minimize DeFi impermanent loss, put liquidity into stablecoins or some other low-volatility asset. Those assets are less volatile so you will have less chance of your investment being immediately worth less when you go to use them, saving you from losing part of your money. For example, pairing USDC with USDT or DAI with USDC can help keep losses to a minimum, as these stablecoins are supposed to behave the same as the US dollar in dollar terms.
To diversify liquidity pools means to spread out one's funds over multiple pools, platforms, and asset types, thereby decreasing the risk and increasing the possibility of more consistent returns. It’s a critical move by DeFi users who want to reduce their exposure to any single point of failure or volatility event. You can apply diversification by asset class, by platform, by strategy, and by blockchain.
Impermanent Loss Protection (ILP) is an insurance provided by some decentralized finance(DeFi) apps against impermanent loss. This provides a safeguard that if the value of the pooled assets ever drops below a certain level as a result of the market's ups and downs, you still receive a certain level of compensation. ILP mitigates the financial impact of impermanent loss, which is especially useful in bear markets with higher price variation over time.
The majority of DEXs charge a standard fee for trading (e.g., 0.3% on Uniswap v2), although certain liquidity pools and platforms increase the trading fee to encourage LPs. These greater fees can boost your yield — especially in pools with little impermanent loss or high trading volume.
More fees = more yield, under good trading volume
Choose high-fee pools in a high-volatility token pair if trading volume justifies it, or if you're okay with less frequent trades, but larger margins.
Liquidity Pool(LP) farming and staking are the two most popular channels to earn passive income in the world of Decentralized finance (DeFi). Here’s a short comparative table with their major features, impermanent loss vs staking:
| Feature |
LP Farming |
Staking |
|---|---|---|
| Description |
Giving liquidity & earning rewards | Lock up tokens in a protocol for blockchain operation and security |
| Typical Rewards |
LP fees + farming rewards | Inflationary token rewards |
| Volatility |
High | Medium to low |
| Impermanent Loss |
Yes, in case of LP token value fluctuation | No |
| Risk Profile | Higher | Lower |
| Reward Type | Trading fees + farmed token | Staking yield |
| Examples | Uniswap/Sushi LP → stake LP tokens on Farm page | ETH 2.0, AAVE staking, Avalanche, Cosmos, Solana |
LP Farming is preferable if:
Staking is preferable if:
Impermanent Loss (IL) is one of the main risks for liquidity providers, especially on volatile or uncorrelated pairs. Thankfully, there are advanced tools, calculators, and platforms that enable you to measure, monitor, and, in some cases, hedge or mitigate IL.
Best impermanent loss calculators and protection tools:
Impermanent loss is the risk usually most hotly debated by liquidity providers as prices differential dramatically. The more the spread of the price, the more the impermanent loss. But it’s not the only danger to think about.
Smart contracts underpin DeFi platforms, and they are not immune to bugs or attacks. There will still however be vulnerabilities. At moments of extreme market stress, liquidity can vanish in a flash. This makes it hard for inverstor to evacuate the total amount of money.
So then, why do people LP farm if it’s that risky?
For all these reasons, a lot of liquidity providers believe the potential rewards are worth the yield farming risks — much like farmers planting seeds in a flood-prone field and hoping for a bountiful crop.
For anyone in the world of decentralized finance, it’s vital to learn how to cope with LP farming impermanent loss. Through a better understanding of these challenges and by employing intelligent tactics, trading, and liquidity-providing parties can make their experience and trading more fruitful and profitable. With DeFi continuing to mature, being informed and flexible can help people take advantage of what is possible in this dynamic space.
