Yield farming is as popular as ever, and farmers still profit from providing liquidity on Uniswap, but how do they deal with impermanent loss? APRs Annual Percentage Rates are still high – however, the high levels of volatility are breaking down the yield farming niche. But what is impermanent loss (IL) in the first place & how much of a problem does it present to Uniswap farmers?
Providing liquidity to pools is always profitable, at least until it isn’t. The infamous IL still haunts liquidity providers (LPs) to this day, and there is no single mechanism that can prevent it. If you are new to Decentralized-Finance (De-Fi) or have never provided liquidity, you probably have never heard of the possible downsides. Here, we will explain the kind of dangers and losses yield-farmers deal must realize and consider.
Essentially, IL is what happens when you join a pool, start providing liquidity, and see the price of the pool’s token drastically change. For example, you have just joined an ETH/LINK (the Ethereum and Chainlink token pairing) liquidity pool and ETH just massively dropped in price. Since you deposited ETH as liquidity before the sharp price drop, you are now vulnerable to IL. Now, the coins you provided as liquidity has lost their value. Your new APR profit cannot even come close to the losses you just took.
Source: Uniswap
Source: Uniswap
But IL does not just apply to cases where the market loses its value even if the price of ETH massively increased – you would still practically miss out on the profitable opportunity. The reason for that is because you just provided liquidity at an earlier price, and you’re only receiving the profits you have made, not the original coins.
Therefore, if you provided liquidity to a Uniswap liquidity pool, you will incur an IL. However, this would not be the case if the volume of the pool’s token pair rises. Since you are profiting on every token swap that any trader makes, their fees will negate your losses.
Source: Trustwallet
Source: Trustwallet
Is There Any Way to Counteract Impermanent Loss on Uniswap?
De-Fi is alive and well for almost a year now. It would seem improbable that someone had already created a feature that prevents impermanent loss from occurring at all, right? Unfortunately, that is not yet the case. Multiple developers attempt to create new Decentralized-Exchanges (DEXs) or change the currently popular protocols to offer a way to avoid losses. However, there is not yet a project/product that completely removes it from existence.
If you are using Uniswap and desire to minimize IL as much as possible, your best bet is to farm in a stablecoin pool. At this point, stablecoins and wrapped tokens are the only way to reduce IL – due to their stability.
For example, if you provide Tether (USDT) to a liquidity pool, there is no way for you to miss out on price increases. The token is always stable, and as such, you have zero risk or losses. The downside of being secure in a stablecoin is that you are missing out on high APR rates. Stablecoins pools are usually the worst LPs in terms of returns for that reason.
Another tactic that you could employ, if you are desperate for high profits, is to provide liquidity only when the entire crypto market ranges. However, you need to be an expert trader and monitor prices constantly to be able to do this.
If you notice that a cryptocurrency is being distributed or accumulated, you can just farm for the time being until the price moves in either direction. Under these conditions, you should search for LPs that have significantly reduced volatility, to ensure that you will not deal with impermanent loss.
As profitable as De-Fi is, the risks associated with these protocols can be considerable. As always, please DYOR (Do Your Own Research) before conducting any of the topics discussed in this article. It also applies to any other article published on this site, or any other site, for that matter.