Investors in the field of cryptocurrency naturally suffer losses at times like investors in other fields. Impermanent loss is one of the most common forms of financial damage in the crypto market in the field of digital currency investment to earn more profit.
Of course, if you have the ability to properly analyze and analyze the information and check the predictions provided by crypto experts, you can avoid suffering these losses to a large extent. Here’s everything you need to know about unsustainable losses.
What is unsustainable loss?
Unsustainable loss In the area Cryptocurrency Occurs when the value Digital currencies Deposited in Cash pool Change (increase or decrease) at the time of withdrawal compared to their value at the time of deposit. In other words, we face the phenomenon of unstable loss when the dollar value of digital currencies invested in the liquidity pool is less than the profit. Holding digital currencies (keeping digital currencies and not investing them to earn more profit).
To better understand unsustainable loss, we must first familiarize ourselves with the concept of liquidity pool. Liquidity pool in simple language is a collection of Staked digital currencies (deposited) by the holders of these currencies to earn profit. Another goal of collecting digital currencies in liquidity pools is Facilitating digital currency exchanges At Decentralized digital currency exchanges Is.
Decentralized digital currency exchanges are a type of Digita currency exchangesare not dependent on third parties for holding assets and their users can exchange their digital assets directly and peer-to-peer with each other (e.g. Bitcoin with Ethereum or vice versa).
Users of liquidity pools can exchange their token pair deposits (two tokens invested in a liquidity pool) on a decentralized exchange with other people. The deposit ratio of the token pair in the liquidity pool is 50/50; Of course Providing liquidity Liquidity pooling is different from cryptocurrency staking.
In the liquidity pool, investors are asked to validate and confirm transactions and blocks in order to earn stake rewards. Blockchain inject cash (or digital currency). The profitability of investing digital currencies in liquidity pools can be much higher than keeping them; But if investors do not act with caution in this field and are not able to perform the necessary analyzes about Unsustainable loss risk If they are not, unsustainable losses can bring heavy financial losses for them.
When does an unsustainable loss occur?
If your profit after investing your cryptocurrencies in liquidity pools is less than the profit you could have made by just holding them, your capital has suffered an unsustainable loss. In fact, such a loss occurs when the price of your uninvested digital currency becomes higher than the invested digital currency in the liquidity pool. This price change makes the value of your deposit share in the liquidity pool lower than the value of the digital currency being traded in the crypto market. The more this price change, the more the deposits are exposed to the risk of unstable losses.
For example, if the value of your deposited assets in the liquidity pool decreases by 10%, but the value of the digital currencies held decreases by 5%, you have suffered a 5% unsustainable loss; Of course, as we said, this loss is unstable and if the price of digital currencies deposited in the liquidity pool returns to the previous level in the market, the loss will be compensated.
However, the amount of sustainable loss is measured compared to when you were holding your currencies instead of injecting them into the liquidity pool; Of course, in some cases, when you cash out your deposit in the liquidity pool, you don’t realize that you have made a loss.
In fact, investors only realize the unsustainable loss when they withdraw their capital in the liquidity pool at the same time as its value decreases; So Investing in liquidity pools It does not necessarily cause losses to liquidity providers; Because liquidity pools have taken different solutions to compensate for unstable losses.
Charging a high fee to earn more profit is one of the ways to compensate for this loss; But if the difference between the value of the held currencies and the currencies injected into the liquidity pool increases, the profit earned from receiving the fee may not be able to compensate the loss. In such cases, if you just hold your digital currencies and do not enter them into the liquidity pool, you will get more profit.
Let us help you better understand unsustainable loss by giving an example.
Imagine you have deposited $500 worth of Ethereum and Bitcoin in a cash pool for each cryptocurrency ($1,000 in total) in a $10,000 Bitcoin and Ethereum cash pool with a 10% stake interest.
Suppose, if after deposit, the price of your ethereum becomes 800 dollars, the pool balance will be disturbed. In such a situation, the liquidity pool officials allow arbitrage traders (traders who want to profit from the difference in prices in two different markets) to buy digital currencies deposited in the pool so that they can sell them in the main market at a higher price.
This will restore the balance of the pool and increase its value from $10,000 to $12,000. If you withdraw the deposited tokens at this time, you will receive $1,200 (10% of $12,000). In such a situation, you may think that you have made a profit of $200 compared to your initial investment of $1,000; But considering that the value of your Ethereum deposit, which was $500 at the time of deposit and became $800 after deposit, you actually lost $100, and if you did not invest your Ethereum in the liquidity pool and kept it alone, your capital Now it was 1300 dollars!
Of course, as we said at the beginning of the article, the decrease in the value of the deposited token also leads to a small percentage of unstable losses.
Where is the source of unsustainable loss?
The source of unstable losses are decentralized exchanges that try to attract investors to provide liquidity to liquidity pools.
How to calculate the amount of unsustainable loss
Calculating the exact amount of unsustainable loss is difficult due to the complexity of some of its variables; But you can estimate the approximate amount of this loss with the following website which is actually an unsustainable loss calculator.
https://dailydefi.org/tools/impermanent-loss-calculator/
To use this calculator, it is enough to enter the price of your two digital currencies (Token 1 and Token 2) at the time of deposit in the Initial Prices section and their price at the time of withdrawal in the Future Prices section, and in the Impermanent loss section, enter the amount of impermanent loss as a percentage. view
In addition, you can see the value of your tokens if held at the bottom of the page in the Value if held section, according to the entered prices, and in the Value if providing liquidity section, see the value of your tokens if you provide liquidity with them.
Unsustainable loss prevention methods
Although it is not possible to prevent unsustainable loss, you can reduce it by following a few principles. These principles are as follows:
- Not investing in digital currencies with price fluctuations: The higher the price fluctuation of the digital currency you want to provide liquidity, the more likely the risk of unstable losses. To reduce the possibility of facing this loss, use only stable coins (Stable Coins) or Bitcoin to provide liquidity.
- Using the AMM algorithm: To avoid financial damage caused by market changes, be sure to Automated Market Makers (AMM) algorithm Use and test it. AMM algorithm It is used to determine the exchange rate of certain token pairs in decentralized digital exchanges. If this algorithm is used, the digital currencies being offered in the decentralized exchange are priced with mathematical formulas. This algorithm works like a robot that determines the exchange rate. In centralized exchanges, prices are determined based on buy and sell orders
- Reducing the amount of investment in the liquidity pool: At first, stake a small amount of your digital currency in the liquidity pool and reduce the risk of unstable losses by spreading your capital in different sectors.
Frequently Asked Questions about Unsustainable Loss in Crypto
If the profit from investing digital currencies to provide liquidity for liquidity pools becomes less than holding them, investors in the cryptocurrency field will suffer unstable losses.
It is not possible to completely prevent such a loss, but by using stable currencies to provide liquidity, benefiting from the AMM algorithm and reducing the amount of staking of digital currencies in liquidity pools, the possibility of facing unstable losses can be reduced.
To do this, you can use calculators for calculating unsustainable losses such as Daily Defi.
