When the value of a certain token ascends or descends after being placed into a liquidity pool, it is called as an impermanent loss. Yield farming has quite a strong connection with impermanent loss, but it is not like staking, because any willing investor must transfer assets into the blockchain in order to confirm and verify any sort of trades and blocks for them to earn any returns.
Since yield farming has the requirement of lending tokens into a liquidity pool, the returns generated are not always the same. Yield farming might seem to generate more profit in the eyes of many, however the risks it comes with can be quite painful to deal with, especially in the case of price controls and volatility. The magnitude of risks involved in impermanent loss basically depends upon the amount of liquidity contributors and tokens that are placed in a liquidity pool.
The tokens involved are bonded with other forms of tokens like stablecoins, some of which included popular coins like Tether (USDT) or the Ether (ETH). Liquidity pools containing these types of stablecoins which have a minimal price range are less susceptible to interim losses, which means that contributors of liquidity will not have to worry about impermanent loss, with stablecoins being mixed in the solution.
The case with automated market makers (AMMs) is very different from others, because liquidity contributors in AMMs are very comfortable in providing liquidity, despite being highly susceptible to temporary losses. Some are curious to why is it like that. The reason for that is trading fee, which can counter those temporary losses.
Looking at the example of liquidity pools on one of the most popular AMMs on Ethereum, Uniswap, although they may be filled with the risks of temporary losses, but they still turn out to be profitable because of the trade fee that is involved.
The perks of impermanent loss protection
Impermanent loss protection acts as a counter measure towards temporary losses that maybe cause harm to liquidity contributors in pools. Contributing liquidity is mostly advantageous on straightforward automated market makers only if the treats of farming are higher than the overall toll of temporary losses.
But the thing to note is that contributors who have been a victim of temporary losses, can utilize the trump card of impermanent loss protection to escape the horrors of impermanent loss. To initiate impermanent loss protection, tokens are to be staked in a farm. This is quite like how insurance works.
To better understand how this protection concept works, lets dive into the Bancor network, on which when someone performs a deposit, the insurance value on that deposit rises in the percentage value of 1% for every day the deposit is actively present. After about 100 days of time, the range reaches its limits and before or after that limit is reached, any sort of temporary loss experienced during that time is taken care of by the protocol.
The thing to be noted is that until those 100 days of time is fulfilled, only a minimal amount of compensation is provided. An example for this is that if a deposit has been present for 50 days in the pool, then only 50% compensation is provided in the case of a loss faced. Furthermore, there is zero compensation provided before the first month of deposit, so contributors must be careful where the tread.
Causes of impermanent loss
The main cause for impermanent loss happens because of the difference between the overall valuation of a loss protection token and the theoretical valuation of a primary token that happens due to no bonding between them.
Looking at the following example scenario will help to better understand how impermanent losses can rise. For example, a contributor holding around 10 ETH is willing to provide liquidity onto a pool which has 50 ETH/50 USDT. In this case the contributor must submit 10 ETH and the equivalent converted amount of USDT, if assumed that 1 ETH is equivalent to about 1000 USDT. If that same liquidity pool holds a total asset valuation of around 10,000 USDT, the share is calculated to be around 20% using this trivial formula.
Share in pool = (20,000 USDT divided by 100,000 USDT) * 100, which equals 20%.
The reason to why the number of contributing participants is high is mostly because when a contributor deposits into the pool via smart contract, they will instantly be rewarded with pool tokens. Contributors also have the power to withdraw their share at any given time by utilizing those same pool tokens.
Now, the question here arises is if there is any loss in assets because of impermanent loss. This is the spot where the concept of impermanent loss comes into play. Contributors of liquidity are now venerable to impermanent loss due to the reason of them being granted a share of the pool, rather than static number of tokens. Now, because a share is now in play, the current value of the initial contribution is now different from what the original value of liquidity was, leading to an impermanent loss.
The thing to note here is the higher this difference in value grows, the higher the impermanent loss is then faced by the contributor. In basic terminology, the loss happens because the value of the withdrawal has degraded from what the initial deposit had.
As the name impermanent loss suggest, the loss can be countered if the cryptocurrency manages to cling back onto its original price valuation. Additionally, contributors also take in 100% of the trade fee that acts as a counter to impermanent loss.
Determining impermanent loss quantitatively
With reference to the example mentioned above, 1 ETH equaled 1,000 USDT at the time of deposit. Assuming that this price is now double, with 1 ETH now equal to 2,000 USDT, the liquidity pool follows a mathematical algorithm that is supposed to configure the pool and take care of the assets inside of it.
Mentioned below is one of the most used formulas, promoted by Uniswap itself. It is known as the constant product formula and is known to be:
Constant Product = Ethereum Liquidity * Token Liquidity
Now, taking the example valuations from above, assuming 50 ETH and 50,000 USDT,
Constant Product = 50 * 50,000, which equals 2,500,000.
Price of Ethereum = Token Liquidity / ETH Liquidity => 50,000/50 equals 1000
Formulae for Liquidity =>
Ethereum Liquidity = Square Root of (Constant Product / ETH Price) and
Token Liquidity = Square Root of (Constant Product * ETH Price)
Now, considering the new price valuation of 1 ETH = 2,000 USDT
ETH Liquidity = Square Root of (2,500,000 / 2000) => 35.355 ETH
Token Liquidity = Square Root of (2,500,000 * 2000) = 70, 710.6 USDT
This calculation can be verified by utilizing the constant product formula.
Constant Product = 35.355 * 70,710.6 = 2,500,000 (Verified)
Old Valuations => 50 ETH and 50,000 USDT
New valuations after price change => 35 ETH and 70,710 USDT
During all this, if the contributor is willing to withdraw the holdings from the liquidity pool, they must now trade their pool tokens for 20% of the share that they possess. Now considering that 20% share, they will receive about 7 ETH and 14,142 USDT.
For now, the valuation of the withdraw equals (7 TH*2,000 USDT) 14,142 USDT, which equals to 28,142 USDT. In the case of these assets being non-deposited in the pool, the contributor would have managed to earn around 30,000 USDT.
This change that happens because of how automated market makers control their asset ratios, leads to impermanent loss.
Impermanent Loss => 30,000 USDT – 28,142 USDT = 1,858 USDT
How to counter this Impermanent Loss
If anyone is willing contribute liquidity, there will always be a chance for impermanent loss present, but they can still utilize some tactics to dodge the risk, like bonding tokens with stablecoins, as previously mentioned.
More on the token bonding strategy, temporary loss can be countered by the bonded pairs that can confidently bet in counter to impermanent loss, because of their stable price fluctuations and many other benefits that reduce the chances of such risks. While the stablecoin bonds may be beneficial, contributors are not able to take advantage of a bullish cryptocurrency market situation.
The strategy is to formulate bonds with those stablecoins that avoid upbringing liquidity into the stableness of the market temporary loss, in comparison to cryptocurrencies that have had a rough past and are unstable in the market. Additional strategy to counter temporary loss includes is to analyze and discover the market, that is mostly volatile in a thorough manner.
Because of this, the assets deposited are already predicted to have change in valuation, so liquidity contributors must understand when to claim the opportunity to withdraw before the difference reaches a value that is harmful.
Temporary loss also has quite a significant presence in decentralized finance (De-Fi) and it shows, because financial institutions hesitate to take part in liquidity pools in fear of loss. But this issue is still fixable if both individual traders and financial institutions take advantage of automated market makers.
Basic look into yield farming
Yield farming is very similar to how interest is earned when storing money in a saving account in a bank, but in the case of yield farming, instead of traditional money, it is cryptocurrencies. In yield farming traders can basically lock their cryptocurrency holdings, also known as ‘staking’, for a said time frame and earn interest and other promotional rewards, which also includes more cryptocurrencies.
According to the president of Hill Wealth Strategies, Daniel R. Hill, when loans are developed in banks, the amount being lent out is then returned with additional interest, so in the case of yield farming, instead of cryptocurrency holdings sitting ducks in an account, they are utilized for lending, which can generate valuable returns. Since its launch two years ago, these returns are earned through annual percentage yields (APY) and can reach impressive numbers.
Yield farming is done when investors stake their cryptocurrency holdings by submitting them to a lending protocol using a decentralized application. Other investors then loan those holdings to speculate and make profits off significant asset price shifting in the market. Applications powered by blockchain bring rewards for those who contribute liquidity in a process called staking, as previously mentioned.
Investment banker, Brian Dechesare states that the loaning process is done mostly using smart contracts, which is basically some lines of code that is operating on the blockchain, acting as a liquidity pool and yield farmers loan their holdings by connecting them with the smart contract.
Staking can lead to the earning of interest and sometimes more cryptocurrencies, which sounds sweet and if the valuations of those same asset’s prices rise, then the returns also rise. Early contributors are awarded, since liquidity gives newly introduced blockchain-based applications a chance to stay alive for the long-term.
Marketing Vice President at Ava Labs, Jey Kurahashi-Sofue said that yield farming is comparable to services like Uber and Lyft, which in their early stages, provided beneficial incentives to users who used their referral links to invite more users on the platform.
Additional incentive for staking is collecting majority of the shares of the cryptocurrency and then receiving the power to suggest a hard fork, which Is basically a major change implemented towards the overall design of the asset, according to Daniel J. Smith, who is an economics professor at Middle Tennessee State University. The hard fork can bring improvements for the cryptocurrency, providing it a new set of directions to operate in the market and transforming it from a cash-based investment to an equity-based investment, said Daniel J. Smith.
Risks of Yield Farming
However, despite all these happy benefits, there is some risk involved, which includes the case of unethical developers deserting projects and then fleeing with the investment they received for the project. This mostly happens due to protocols and coins facing rough situations like volatility and rug pulls.
There are many other risks that come with yield farming that must be understood to gain the most information and be aware of the challenges that follow it.
First is volatility, which is basically the degree of change in the price of an asset. The higher this degree, the higher the price change happening in limited time. If the tokens being staked are subject to volatility, there is no telling if their prices will rise or fall flat, leading to losses.
Second is fraud, in which yield farmers put their trust and stake into unsuspected fraudulent projects, which then run off with their investment after a said time, without providing anything back to the investor. According to a report published by CipherTrace, fraudulent activities had a major role in the total crimes, worth $1.9 Billion back in 2020.
Third is rug pulls, which is a form of exit scam in which developers accumulate funds for a visionary project, later abandoning it without any return to the investor. This is very similar to fraud risk and happens to play a major part in crimes reported worldwide by CipherTrace.
Fourth is smart contracts. Now smart contracts might very beneficial, but it still a piece of code which can have bugs and can be hacked, leading to risks over the cryptocurrency investments made. Kurahashi mentioned that improved third party audits must be used to maintain the security and functionality of smart contracts.
Fifth up is regulation issues, as cryptocurrencies are still being questioned around the world for their regulation issues, many lending platforms have been a target of authorities because of this.
And finally comes Impermanent loss, in which when cryptocurrency investor holdings are staked, their price could fluctuate, leading to temporary unwanted gains or losses. The problem is that those gains or loss stick if the investors withdraw, which then leads to loss if the earned value is lesser than the value that has been lost.
Kurahashi stated that decentralized applications always carry some sort of risk and countering those risks is the game to utilize those applications effectively, so users should always do a background check of the application they use and must know about is intentions towards security checks.
While yield farming can have many risks, it can generate a lot of profit if utilized in an effective way. There is a reason to why this concept still exists, otherwise if it only had risks, no one would be taking part in it. There are tons of very successful pools present in the market, however their change of impermanent loss is quite high, so investment into liquidity pools is still said to be debatable and based on pure market speculation.
So, in the end, if someone is to profit from yield farming, these must be aware of the risks and be highly knowledgeable of the market to understand price movements clearly.
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