Lecture 3.1.0. How to Mitigate Impermanent Loss
Impermanent Loss is real, and you should weigh it before you enter into yield farming.
The good question many yield farmers are asking is: “Is there a way to mitigate or even eliminate impermanent loos?”
Here are some answers:
(1). Seek Yield Farms with High Rewards
To compensate for such impermanent loss, yield farm protocols offer some incentives such as allowing you to farm and receive utility tokens as rewards besides the transaction fees. As mentioned above, such rewards often carry high rate of return on investment such as 3000% APR. Where can you get such highly lucrative yield?
Often, with cheaper Blockchain charges as seen in Binance smartchain and the high rate of return on investment, impermanent loss does not become a major challenge. The yield farm rewards often outperform the impermanent losses so that the yield farmers still make good, insane profits.
(2). Provide Liquidity with Stablecoins
The more a crypto is volatile in price, the higher the impermanent loss. Among all cryptocurrencies, stablecoins are the least volatile in price movement. Hence, using them for yield farming reduces the amount of impermanent loss.
(3). Provide Liquidity to Pools with Unevenly Weighted Cryptocurrencies
Another way to mitigate impermanent losses is to provide liquidity to pools with unevenly weighted cryptocurrencies.
Some liquidity pools allow the supply of unevenly weighted base-pairs such as a liquidity ratio of 75/25. For example, Balancer allows a liquidity ratio of 75/25 for Maker (MKR) and Wrapped Ethereum (WETH).
In such a case, if MKR increases in price, your impermanent loss will be less. However, if WETH outperforms MKR, your impermanent loss will be greater in a 75% MKR 25% WETH pool compared to a pool with equally weighted 50% MKR and 50% WETH.
Two Factors to Consider
Therefore, for you to suffer less impermanent losses when using unevenly weighted base-pairs, you should consider two factors:
(a). Bullishness
Bullishness is when a crypto goes up in price. Let’s say you have Maker (MKR) and you plan to yield farm. First, analyse the facts such as MKR trading community, current price movement of the crypto, etc.
Based on your analysis, do you think MKR price will go up? In other words, are you bullish on MKR?
If yes, then consider the second factor – the Liquidity/Volume Ratio.
(b). Liquidity/Volume Ratio
The Liquidity/Volume Ratio is often abbreviated as LVR. There are two elements in LVR:
• Liquidity value – refers to the total amount of the base-pairs supplied to the liquidity pool and it is known as Total Locked Value (TLV).
• Volume value – refers to the volume of trades that go on in the liquidity pool in a specified time, usually given in 24 hours.
When you divide TLV by the volume of trade within that pool, you will get the Liquidity/Volume Ratio.
The TLV and the volume in 24 hours are usually provided as part of the statistics in any user interface such as Uniswap or Pancakeswap. Hence, you don’t need to do the calculations yourself – all you do is to look for them.
Interpretation of LVR
A lower LVR means that the cryptos in the pool are getting traded more frequently and more rapidly than the ones with a high LVR.
Don’t be confused at all about LVR; it’s easy to understand. You compare LVR of one pool to another. The one with a low LVR is preferable to a high LVR. A low LVR mean that the volume of trade is high and the pool is very active unlike the pool with a high LVR.
If the LVR in the unevenly weighted pool (e.g. 75/25%) is lower than the LVR of the evenly weighted pool (50/50%), you may choose to yield farm the unevenly weighted pool.
(4). Watch Out for New Innovations in New Yield Farms
Indeed, the presence of impermanent loss is keeping some big investors such as institutions from yield farming. As such, many ideas are being experimented to find a way to mitigate or completely remove impermanent losses for liquidity providers.
For example, in May 2019, 1inch Liquidity Protocol that runs on Ethereum smartchain has introduced virtual balances which decreases the profit of arbitrageurs due to temporarily mispriced pools, leaving more profit for liquidity providers.
According to 1inch whitepaper, the target is to generate from 50% to 200% more income for liquidity providers than Uniswap due to redirection of price slippage profits to liquidity providers.
Thus, watch out for newer user interfaces like Bakeryswap that runs on Binance smartchain. They may offer better services that mitigate or completely eliminate impermanent losses.