Part and parcel with Don-key’s mission to bring yield farming to the masses is our goal to educate the crypto space and the mainstream in general on DeFi’s cutting edge. Today we kickoff a series of articles designed to do exactly that, starting with the basics with a plan to move on to more advanced material in the future. Because everything at Don-key is intended to be fun and accessible, our content will be high level yet digestible so that we can reach the largest possible audience. In today’s entry, we’d like to introduce our fellow Don-keys to the basics of impermanent loss.
Many newbies have jumped head first into yield farming without any knowledge whatsoever of impermanent loss; woe be to them. Ignorance here is costly and can easily result in the disappearance of potential gains. For those who don’t know, in the most general sense, impermanent loss is a common kind of logistical risk associated with liquidity mining.
Liquidity mining is the foundational yield farming layer in which token holders provide liquidity (their staked tokens) alongside a base token to decentralized exchanges, borrow-lend protocols, insurance platforms, or many other types of innovative protocols which require liquidity. In exchange for locking up their funds, liquidity miners are given liquidity tokens which are used to collect staking rewards and protocol fees. Given liquidity needs at the time, APY can be extremely generous and can make liquidity pools an attractive place to park one’s investment.
The Risks of Impermanent Loss
The hidden big bad danger is, yup — you guessed it — impermanent loss. Practically, it is a logistical side effect of algorithms used by automated market makers, like Uniswap, to adjust the ratios of assets in a pool and determine their prices. These algorithms are crucial to decentralized exchanges, but they also result in impermanent loss.
Because liquidity pools must maintain balance between invested tokens, price volatility between the tokens erodes their collective value. Let’s say, for example, Elon Musk decides to provide Pancake Swap with Don-key liquidity and deposits 1,000 dollars in DON alongside a required base token WBNB, also worth 1,000 dollars. If Don-key doubles in value, but Binance Coin stays the same, then the added 1,000 dollars in Don-key would be distributed among the pool so that the total dollar value of WBNB and DON are equal. Thus Elon would lose out on DON’s increased value. Alternatively, if WBNB lost half its value, then the liquidity pool would automatically convert DON tokens into WBNB in order to maintain stasis at a 50:50 dollar ratio between the paired tokens; again, poor Elon would lose out on DON profits.
Importantly, this loss of value is called impermanent because it only materializes when a liquidity provider exits their position. If balance between tokens is restored organically, due to the normal movements of the market, then impermanent loss disappears as the invested tokens reclaim a dollar ratio nearer 50:50.
While impermanent loss is a factor worth considering, the benefits of liquidity mining often offset it with generous APY.
Don-key Copy Farming
Given liquidity mining and by extension yield farming’s incredible complexity, most of the crypto retail market avoids them both entirely. Perhaps, for good reason; with constantly shifting risks and rewards, keeping oneself updated is almost a full time job. This is exactly why the Don-key platform was created: So that you can enjoy yield farming’s high profitability without having to sacrifice the time and energy needed to do it actively. With Don-key’s one click copy- farming, DeFi has never been more accessible. Stay tuned for more updates. The team has a lot of surprises in store!
Contributed by Jason Kelman