Yield farming is growing in popularity as a means of earning interest and gaining rewards, but it does have the risk of impermanent loss. What is this concept and is there a way you can avoid it?
What is impermanent loss protection?
To activate ILP, tokens must be staked on a farm. Let's use the example of the Bancor Network to understand how ILP works. When a user makes a new deposit, the insurance coverage provided by Bancor grows at a rate of 1% per day the stake is active, eventually reaching full range after 100 days.
Let's look at a hypothetical situation to see how impermanent/temporary loss occurs. Suppose a liquidity provider with 10 ETH wants to offer liquidity to a 50/50 ETH/USDT pool. They'll need to deposit 10 ETH and 10,000 USDT in this scenario . This is where the idea of IL enters the picture. Liquidity providers are susceptible to another layer of risk known as IL because they are entitled to a share of the pool rather than a definite quantity of tokens. As a result, it occurs when the value of your deposited assets changes from when you deposited them.
The most basic and widely used is the constant product formula, which is being popularized by Uniswap. In simple terms, the formula states: Similarly, the price of ETH in the pool can be obtained using the formula:Now the new price of 1 ETH=2,000 USDT. Therefore,ETH liquidity * token liquidity=35.355 * 70, 710.6=2,500,000 . So, now we have values as follows:
This difference that can occur because of the way AMMs manage asset ratios is called an impermanent loss. In our impermanent loss examples:Liquidity providers cannot avoid impermanent loss completely. However, they can use some measures to mitigate this risk such as using stablecoin pairs and avoiding volatile pairs.
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