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The crypto ecosystem has no shortage of jargon. Ambiguous phrases, acronyms, and newly formed words that had almost no meaning a decade ago (or even a few months ago for many) are now widely used market signals informing strategic investment decisions. As Cryptocurrencies are natively digital, it is important to understand the vernacular, usage, and meaning of the digital vocabulary that has formed within the space.
Most investors will be familiar with the concept of opportunity cost when choosing where to allocate their assets. But those that are not embedded at the forefront of the emerging decentralized lending ecosystem may not yet be exposed to the concept of impermanent loss and how it relates to this fundamental economic principle. While the two are similar at a conceptual level, there are several factors unique to the DeFi space that make impermanent loss a more nuanced consideration for investors and traders.
Impermanent loss is the temporary loss of funds while providing liquidity to a liquidity pool. It is the difference between the asset value traders would have if they just held their assets on an exchange or in a wallet, versus the asset’s value after contributing funds to a liquidity pool. Liquidity pools operate through liquidity providers contributing equal amounts of two assets to a liquidity pool in a 50/50 ratio. Most often, one of these assets is a token (whose price is volatile) while the other is a stablecoin (whose price is stable). If the price of the token (volatile asset) increases on the market, the pool must rely on participants to spot this arbitrage opportunity and bring the prices back into alignment.
This is achieved by arbitrageurs purchasing the volatile token asset from the liquidity pool at the lower price and selling it at a more favorable price elsewhere for a profit. Because liquidity pools rely on a mathematical formula that adjusts price based on demand, the volatile asset price will steadily increase until the liquidity pool value and market value have once again been brought into alignment. While the value of the liquidity providers initial investment has appreciated still during this arbitrage event, the increase is not as much as what they would have earned had they not participated in the pool and simply held their assets on an exchange. Impermanent loss is ultimately the opportunity cost difference between the value of assets held in the pool versus the value of assets held in the open market.
It is important to note that a liquidity provider’s loss is still “impermanent” because, like all gains or losses, they have not yet been realized. If the provider continues to hold their assets in the pool and does not realize this event by cashing out, the loss has not yet been made permanent. Despite the impermanent loss that many liquidity providers may experience from rising asset values and arbitrageurs, they often choose to keep the assets in the liquidity pool because of the fees they earn from others that utilize their assets locked in the liquidity pool. Therefore, even with significant amounts of impermanent loss, it may still be profitable for liquidity providers to retain their assets in the pool because of the earnings generated from these fees is higher than the opportunity cost of simply holding the asset without providing liquidity.
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