Hedging Against Impermanent Loss

If you’ve been around in the crypto industry for a while, you’ve probably noticed at times that some tokens that have risen in price and value have no liquidity when you try to sell.

When decentralized trading exchanges do not have enough liquidity, this is a huge problem, a strong reason why Linear Finance plays a huge role by providing high liquidity on their exchanges. When there is no liquidity, it results in high slippages, which is not healthy for traders.

Since the emergence of DeFi, providing liquidity to AMM (Automated market makers) has been a thing of the norm. As an investor, becoming a liquidity provider (a type of investment in which you lend your tokens to earn rewards, also known as yield farming) offers a new option to make money.

Liquidity providers are required for liquidity pools to function properly. They provide liquidity to the liquidity pool and are rewarded or get a share from the trading charges.

While this type of investment looks attractive, liquidity pools come with a risk known as impermanent loss. Although this loss can be mitigated later, it’s still important for investors to be aware of it and know the strategies to hedge against it.

What is Impermanent Loss?

The drop that occurs when the price of the assets you’ve deposited to a pool fluctuates between deposit and withdrawal is referred to as impermanent loss. If the difference is greater, you will suffer a greater loss; if the difference is smaller, you will suffer a smaller loss. As the name implies, it is an impermanent loss of funds, i.e., temporary, and it is usually experienced owing to volatility in a trading pair.

In the Liquidity pool, two assets are always paired together, mostly a stable coin, say DAI, and a volatile coin, say ETH.

Let’s assume a liquidity provider offers an equal level of liquidity in both DAI and ETH, and suddenly, ETH goes up.

When this happens, the price of ETH in the liquidity pool will not reflect what’s going on in the real world; this presents an appealing arbitrage (Arbitrage is the simultaneous purchase and sale of the same asset in multiple marketplaces to profit from minor price discrepancies) opportunity. Other traders will buy ETH at a discounted cost until the ratio of DAI to ETH reaches equilibrium again, ensuring that the ratio of DAI to ETH remains balanced. Due to this, a liquidity provider may have slightly more DAI and slightly less ETH after arbitrage.

This is exactly what impermanent loss is. However, the loss becomes permanent only when providers permanently withdraw their liquidity.

STRATEGIES TO HEDGE AGAINST IMPERMANENT LOSS

Let’s look at some strategies to reduce your vulnerability to impermanent loss.

Stablecoin Pairing

Instead of coins with volatility, consider Stablecoins to pair. You will not be exposed to any risk of impermanent loss if you supply liquidity to a pair like USDT/USDC because they are stable, as the name says. This is a good technique in a bearish-down market because you’ll still profit from trading costs.

Low Volatility Pairs

By avoiding more volatile cryptocurrency combinations, you can prevent impermanent losses. It would be best to opt for a more stable or low volatile combination.

For example, if you intend to supply liquidity to a specific crypto pair and, after conducting a “DYOR” market research analysis, you believe one of them will soon outperform the other, don’t do so. On the other hand, if you think both assets will rise or fall in price relative to each other, you’re set to go because the difference won’t be significant.

In a nutshell, keep an eye on volatile currencies’ current and future performance.

Waiting

When you supply liquidity to a crypto pair, the market price of that pair will inevitably fluctuate, which will always cause loss. When this occurs, you can hold off on withdrawing your assets until the crypto gain and recover to their initial prices. However, because the cryptocurrency market is highly volatile, this isn’t as easy as it may appear.

Final Thoughts

The backbone of DeFi and DEX is liquidity pools, which address the liquidity issue that drives customers to use high slippage during trading. A significant reason Linear Finance came into the limelight so as to protect its users’ investment by providing high liquidity to its decentralized exchange and a minimal to a near-zero slippage to ensure smooth, seamless trading and benefits for traders.

About Linear Finance

Linear Finance is a cross-chain compatible, decentralized delta-one asset protocol that allows users to get synthetic exposure to various assets, including cryptocurrency, commodities, and market indices. Users can utilize our cross-chain swap functionality to instantly swap assets across leading blockchain environments and DeFi protocols with unlimited liquidity and zero slippage.

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