DeFi: lending, liquidity and impermanent loss
DeFi is where the yields are and where the losses are. Both come from the same place: you are being paid to take a risk somebody has named badly.
Providing liquidity is not saving
When you add to a liquidity pool you deposit two assets and earn a share of trading fees. What you are actually doing is running a small market making business: you automatically sell whichever asset is rising and buy whichever is falling.
Impermanent loss, explained properly
If one asset moves a long way against the other, you end up holding more of the loser and less of the winner than if you had simply held both. The gap between your pool value and just holding is impermanent loss. It becomes permanent the moment you withdraw.
It is not a fee and nobody takes it from you. It is the arithmetic of automatic rebalancing, and on a volatile pair it routinely exceeds the fees you earned.
- Two assets that track each other, such as two stablecoins
- High volume pairs where fees are substantial
- Positions you will hold long enough for fees to accumulate
- Amounts you understand you might get back in a different ratio
- A volatile token paired against a stablecoin
- Chasing a headline yield on a new pool
- Pairs where the yield is paid in a token that is itself falling
- Anything you would be upset to receive back in the wrong proportion
DeFi lending and liquidation
You deposit collateral and borrow against it, always less than you deposited. If your collateral falls, your health factor falls with it. Cross a threshold and anyone can liquidate you, repaying your debt and taking your collateral plus a penalty.
BEFORE YOU MOVE ON
Common questions
What is impermanent loss?
The shortfall between the value of a liquidity position and simply holding the two assets, caused by the pool automatically rebalancing as prices diverge. It becomes permanent when you withdraw.
Is DeFi lending safe?
The established protocols have long records, but you take contract risk, oracle risk and liquidation risk. Borrow far below the maximum and know your liquidation price before you start.
Risk warning: crypto is highly volatile and largely unregulated. You can lose everything you put in. Nothing here is financial, investment or tax advice.