The difference between the current price of the token locked in the protocol and the price difference when it is deposited into the stake pool is called Impermanent Loss.
In other words, temporary loss is the difference in value between keeping cryptocurrencies in the wallet without making any transactions instead of depositing them in the liquidity pool.
The temporary loss seen in the decentralized finance (DeFi) ecosystem is determined by the rate of change in the token price. The value change of the protocol locked token from the beginning to the end of the staking process causes temporary loss.
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Decentralized finance protocols make it possible for anyone with tokens to become a market maker and earn income from transactions taking place on the network, without any limits. Although it is a democratic solution, it may contain momentary risks such as temporary loss.
Although liquidity is provided to make a profit and tokens are locked in related pools under normal conditions, due to the risky nature of Automated Market Maker (AMM) protocols, sudden fluctuations in token price may cause temporary loss problem.
In pools that allow trading with high volatility assets, the probability of temporary loss is higher. In this context, options such as a stablecoin whose value is pegged to any fiat currency or a wrapped version of a highly reliable cryptocurrency offer less price volatility. Consequently, their risk of temporary loss is also low.
Is the temporary loss really “temporary”?
Users who provide liquidity to decentralized finance protocols can continue to keep their assets locked even if they experience temporary losses. The reason for this is that even if there is a temporary loss, the revenues from transactions on the network continue to come to the user. In some cases, even if the user’s asset has depreciated, it is still possible to move into a profitable position with the proceeds from transaction fees. For this reason, the loss is called “temporary”.
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How does temporary loss occur?
When the liquidity provider locks crypto money into the pool, it receives a certain share from that pool. It also earns income in proportion to its share while leaving the pool. The earnings from transaction fees are added to the total share in the liquidity pool.
The seemingly extremely profitable liquidity process can be directly affected by sudden changes in market prices and arbitrage users.
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Let’s examine with an example:
$ 100 of 1 ETH; Suppose 1 UNI is also $ 1 and an equal value (50/50) coin must be added to the liquidity pool.
Investor; According to AMM rules, it locks 1 ETH and equal 100 UNIs to the system. In other words, it would have invested a total of 200 dollars.
Suppose there are a total of 1,000 ETH and 100,000 UNI in the pool, and the total liquidity is calculated at 1 million level. The investor’s share in this pool will be 0.1%.
Let’s assume that the price of ETH, which was $ 100 at the beginning of the transaction, increased to $ 400.
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In such a case, users will perform arbitrage transactions until the token price in the protocol is equal to the price in the spot market. In this process, new UNIs will be added to the pool and ETH will come out of the pool whose value is increasing in the spot market.
Even if total liquidity remains constant at 1 million, the amount of assets in the pool will also change.
Let’s assume that the investor wants to withdraw their funds while there are 500 ETH and 200,000 UNI in the pool at the end of arbitrage transactions. Since its share is 0.1%, it will leave the pool by taking 0.5 ETH and 200 UNI.
In the example we gave, the user got $ 400 ((0.5 x 400) + (200 x 1)) by investing $ 200. Whereas, if the investor had never traded instead of providing liquidity, he would have had a total of $ 500 thanks to the increase in value in the spot market ((1 x 400) + (100 x 1)).
The $ 100 difference is a temporary loss.
Not: For the sake of understanding the given example, the gain from transaction fees in the liquidity pool has not been included in the account. The investor earns income from the transaction fees during the process of locking their assets into the protocol, and as long as the prices in the spot market do not fluctuate much, they can become profitable.
WARNING: Be careful when trading through the automatic market maker. The temporary loss rate of each liquidity pool is not the same. The higher the price volatility of the currencies within the pool, the more likely it is to experience temporary losses. Make sure you research enough before trading on AMMs. Remember that if a pool promises much higher returns than others, the risk is higher. If you are new to the industry, trade with amounts you can sacrifice, risk taking.
DISCLAIMER: The statements contained here are not investment advice. Never trade without researching the markets thoroughly and without comments from different circles. Read the comments of the investors you trust, consult their opinions. Remember that every trading transaction involves risk. Make your own decision when taking any action. Cointelegraph cannot be considered directly or indirectly responsible for any damages or losses arising or allegedly arising from investment products or services.