Understanding Impermanent Loss in DeFi and How to Avoid It: A Guide from PancakeSwap

What is Impermanent Loss?

Impermanent loss occurs when the value of assets in a liquidity pool diverges from their initial value. This divergence happens as the automated market maker (AMM) adjusts the asset ratios in the pool to maintain balance. When the price of one asset rises or falls significantly compared to the other, liquidity providers (LPs) may face a loss compared to simply holding the assets outside the pool.

How Does Impermanent Loss Happen?

Price Fluctuations: When you add liquidity to a pool, you provide two assets in a 50/50 ratio (e.g., BNB/USDT). If the price of BNB increases while USDT remains stable, the pool will adjust the ratios to reflect the new prices. This adjustment can lead to having more USDT and less BNB, potentially resulting in a loss if you withdraw your liquidity.

Market Volatility: In highly volatile markets, the price changes of the pooled assets can be drastic. The more significant the price change, the larger the impermanent loss.

Arbitrage Activities: Traders exploit price differences between the liquidity pool and external markets to make a profit. Their trades adjust the asset ratios in the pool, potentially leading to impermanent loss for LPs.

Example of Impermanent Loss

Twinkle decides to provide liquidity to the BNB/USDT pool on PancakeSwap. She deposits 1 BNB and 500 USDT, with the price of BNB being $500 at the time. The total value of her deposit is $1,000. Over time, the price of BNB increases to $800, but the pool adjusts the ratios to maintain balance. Twinkle now has 0.774 BNB and 619.2 USDT in the pool. If she withdraws her liquidity, the combined value of her assets is $1,235.36 instead of the $1,300 she would have if she simply held her 1 BNB and 500 USDT. The difference, $64.64, is her impermanent loss.

How to Minimize Impermanent Loss

Choose Stable Pairs: Provide liquidity to pools with stable assets like stablecoins (e.g., USDT/USDC). These pairs experience minimal price fluctuation, reducing the risk of impermanent loss.

Diversify Your Investments: Don’t put all your assets into one liquidity pool. Diversifying across multiple pools can help spread the risk.

Use Impermanent Loss Protection: PancakeSwap works with Position Manager partners to provide strategies that can minimize impermanent loss.These strategies adjust LP ranges based on market volatility and directional trends, automatically rebalancing itself to maximize fees while minimizing the strategy's impermanent loss, providing an automated LP experience to the liquidity providers.

Try Position Manager: https://pancakeswap.finance/position-managers

Stay Updated: Monitor the market trends and the performance of your liquidity pools regularly. Being aware of significant price movements can help you make informed decisions about when to add or remove liquidity.

Expect the change by PancakeSwap v4

PancakeSwap v4 promises to bring custom pools and gas optimization, enhancing the overall DeFi experience. PancakeSwap v4 introduces several new features designed to make the platform more efficient and user-friendly. One of the key features is Liquidity Book Pools, which follow the formula X + Y = K instead of the traditional X * Y = K. This new type of pool allows liquidity providers to experience no impermanent loss and traders to suffer no price impact when trading within a bin. The Liquidity Book AMM utilizes a constant sum formula within each bin, ensuring zero price impact trades and eliminating impermanent loss for LPs. Additionally, the fungibility of liquidity makes position adjustments cost-effective for LPs, supporting single-sided liquidity provisioning and enabling native limit orders akin to an order book model. This is the first Liquidity Book AMM implementation supporting hooks, allowing developers to introduce tailored features and optimizations to these pools.

Understanding impermanent loss is important for anyone participating in DeFi and providing liquidity on PancakeSwap. By comprehending how it works and implementing strategies to minimize it, you can maximize your returns and minimize risks. Always stay informed and make decisions based on thorough research and market conditions.

Cheers The Chefs

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