Impermanent loss is the loss of value due to the provision of liquidity to automated market makers (AMMs). It is the inherent risk of providing liquidity in DeFi. Understanding how to manage this phenomenon can enable liquidity providers (LPs) to better provide liquidity to AMMs. This article will outline some different strategies and teach you how to reduce I.L during DeFi activities.

The following are some of the most basic strategies for mitigating impermanent losses:

  1. Avoid high-volatility liquidity pools

    Cryptocurrency assets like ETH are not tied to the value of external assets like stablecoins, so their value will fluctuate with market demand.

    It should be noted that the liquidity pool centred on volatile assets is the largest source of impermanent loss risk. Although crypto blue chip stocks such as ETH and WBTC may be more volatile, other small currencies face a greater possibility of intraday price fluctuations. So from the perspective of impermanent losses, they are riskier.

    If avoiding impermanent losses is the most important aspect for you, then a wise choice is to avoid providing liquidity to highly volatile liquidity pools.

  2. Provide liquidity to stablecoin pairs

    Stablecoins such as USDC and DAI are pegged to the value of the U.S. dollar, commodities or gold. As such, their valuations remain free from wild swings. The narrower the range of price changes, the lower the impermanent losses.

    In liquidity pools that are pegged to a similar asset (such as the USDC/DAI pool), the volatility between these tokens is small. This dynamic will naturally cause little impermanent loss to LPs. Therefore, if you want to become an LP and earn fees, but don't want to face a lot of impermanent losses, then choosing to provide liquidity to these liquidity pools is a good choice. Be reminded that, since the risk is lower, the percentage return is usually lower too.

  3. Pair tokens with similar volatility rates

    If you know the prices of Token A and Token B will increase by 50% after a period of time whereas the prices of Token C and Token D will decrease by 50%, then you should pair Token A with Token B or pair Token C with Token D. If the pairs' prices increase or decrease at similar rates, the impermanent rates will be near to zero. Oppositely, if you pair Token A with Token C, the impermanent loss will be maximized.

  4. Choose a liquidity pool with unevenly weighted assets

    A liquidity pool with unevenly weighted assets means that the asset value ratio in the pool is not a traditional 50/50. BALANCER is well-known for creating this flexible liquidity pool. The asset ratio in the liquidity pool on the platform can be 95/5, 80/20, 60/40 and so on.

    These asset ratios will have an impact on impermanent losses. For example, based on the 80/20 AAVE/ETH pool, if the price of AAVE rises relative to the price of ETH, then most of the risk exposure of the LPs in the pool is AAVE (accounting for 80% of the pool). So the impact of impermanent loss caused by price fluctuations is less than that of LPs providing 50/50 liquidity for the AAVE/ETH pool.

    Therefore, providing liquidity to such an imbalanced liquidity pool is also a way to alleviate impermanent losses.

  5. Go STAKING!

    Instead of providing liquidity, you may also consider staking your assets. Unlike LPs, the risk of staking is usually much lower as it suffers from zero impermanent loss. Although the interest rates of staking are usually much lower, it is still possible to earn more than L.P. during periods of huge price swings.

  6. Wait for prices to go back to the initial rates

    The term "impermanent" is used to describe something "temporary". As long as you do not withdraw your fund from the pool, you still have a chance. The process of impermanent loss can sometimes be reversed. You can wait until the difference in price change percentage between the two assets goes as near to zero as possible (the initial level) before leaving the pool. You will need plenty of luck.