Lecture 3.0.0. Impermanent Loss
But you may ask: Is there no risk in yield farming?
Of course, every investment has its own risk. The most common risk in yield farming is Impermanent Loss.
Impermanent loss is when a liquidity provider has a temporary loss of funds because of price volatility of the liquidity pair. This is explained better by the following example.
Let’s say you have decided to yield farm using Uniswap, which is one of the most popular Ethereum blockchain yield farming platforms. Let’s say you have chosen to use Dai and Ether (ETH) for yield farming.
That means the base-pair you will supply to the liquidity pool in Uniswap will be DAI/ETH, and Uniswap’s ratio for this base pair is 50/50. Meaning, the values of DAI and ETH in the liquidity base-pair are the same.
DAI is a stablecoin, hence, its price does not really change unlike ETH, which can fluctuate easily with market movements. If the price of ETH goes up in the Crypto Market, it means the price of ETH in the liquidity pool will now be lesser than the price of ETH in the Crypto Market.
Traders will see this difference in ETH price and they will want to profit from it. The traders will start to buy the under-priced ETH in the liquidity pool. Each purchase will increase the price of the ETH until the price rises to be at same level as the price in the Crypto Market.
Such traders are called arbitrageurs and the transactions are called arbitrage trade.
Thus, the profits the arbitrageurs made from the trade are actually some of the ETH that form the DAI/ETH pair in the liquidity pool. This means if you withdraw your DAI/ETH pair from the liquidity pool at this point, the amount of ETH you will get will be smaller than the amount you have deposited at the beginning of your yield farming.
In other words, you have lost some of your ETH for using it as a base-pair to provide liquidity unlike if you had simply left your ETH in your wallet. This loss is called Impermanent Loss.
The good news is that if the price of ETH goes back to the same level as when you started the yield farm, you will recover the loss as a result of the interest (transaction fees) you will receive. This is why it is called Impermanent, which means it is not a permanent loss.
It only becomes a permanent loss if you decide to end the yield farming by pulling out your cryptos.