By now, unless you have been living under a rock, you have heard the phrase impermanent loss. Well, like me, I'm sure the ordinary small investor does not understand what impermanent loss is. This lack of understanding on my part required me to do some research which I share with you in this article.
Understanding impermanent loss at first blush may seem confusing. It is not. Impermanent loss is a temporary loss of funds a liquidity provider exhibits due to price volatility in a trading pair. Simply put, this loss occurs when liquidity is applied to a pool and the price of the assets deposited in the pool change over time from the time deposited. The bigger the change in the underlying asset price, the more exposure to impermanent loss is present. Of course, this loss is not realized until the position in the liquidity pool is terminated.
There are, however, pools available on Harvest Finance (and others) that can mitigate the risk of impermanent loss. Any liquidity pool including Stablecoins in the pairing mitigates the risk of impermanent loss as the price of the Stablecoin is less volatile than the price of cryptocurrencies such as BTC and ETH. The inclusion of the Stablecoin in the pairing provides some degree of price stability based upon the fixed price structure of the Stablecoin itself. So if you pick a liquidity pairing with a Stablecoin and avoid volatile crypto pairs, your risk of impermanent loss is diminished. It should also be noted that by participating in an incentivized liquidity pool with participation in liquidity mining, as offered by Harvest Finance, acts to mitigate risk of impermanent loss.
I believe there is a trade off between risk aversion and yield. Liquidity pairs with riskier assets tend to provide better yield than those containing Stablecoins. Take for example: ETH-1INCH @ 192.24%; WBTC-KBTC @ 1579.93%; and, WBTC-KLON @ 1944.52% whereas the yield on Stablecoin pairs range between 7.52% and 41.34%. Indeed, a big difference. (All yields presented are as of the time of the writing of this article from Harvest Finance). The bottom line: if you want to minimize the risk of impermanent loss to your investment by utilizing Stablecoin pairs, you may have to sacrifice some yield in the process.
In my opinion, investing in Liquidity Pools is not an investment for the new investor. The process requires knowledge developed over time and varied experiences in investing. But if you are researching Cryptocurrencies and land upon impermanent loss I hope this article provides a simplified basic explanation of what it is and how it works.
I am merely an ordinary small investor who likes to share what I've learned through research into the Crypto World. I am very bullish on Harvest Finance but I am not in any way a financial advisor and as such, do your own research before investing. If you enjoyed this article please like it, comment and/or tip. Feedback is always welcome here.
