Impermanent Loss explains hello and welcome to my channel Crypto Explained! I am really happy that you are there and I assure you that after this video you have fully understood what the so-called "impermanent loss" is. We will look at the following: First we clarify how the price is created on a decentralized exchange, look directly at an example and think about how you can avoid such a loss. The impermanent loss is one of the most important risks that arise when participating in so-called liquidity mining. We'll pretend you're just getting into LM and then see what can happen. At this point I would like to make a disclaimer: The numbers that we will use in the examples are very imprecise and probably not up-to-date. The calculations are greatly simplified, but the principle becomes clear for you as an investor and that is the subject of this video.
Let's say you would now like to take part in DeFiChain's liquidity mining and you have now thought about investing 5 bitcoins, for example . This is of course applicable to all other pools. The ratio of a couple in the DeFi Chain is always 50-50, which means in the end you need the equivalent of your 5 BTC, i.e. 200,000 DFI. So your stake is 5 BTC and 200,000 DFI. So far so good. Now let's take a look at what's in the pool. The pool is still small and currently there are only 20 BTC and 800,000 DFI in the pool. With your investment, there are 25 BTC and 1,000,000 DFI in the pool. So you hold a share of 20% in the whole pool. Now a couple of hours, days or weeks may go by and out of nowhere and for some reason the price of DFIs doubles and you are wondering if you should take a few DFIs out of the pool to sell them. No sooner said than done, you open your wallet and find out with a shock that your number of coins has changed.
You now have more BTC and less DFI than before and let's see why. The moment the price of DFI has risen, the ratio of the coins in the pool changes. The price on a decentralized exchange is always based on the ratio of the coins. There are no order books here like on a central exchange! However, this adjustment does not happen entirely by itself, someone is responsible for it and even if in most cases there are some programs or bots that take care of it, we are talking about so-called arbitrage traders. Even if the translation of arbitrage is of no help, arbitrage traders are nothing more than normal traders who specialize in taking advantage of price fluctuations between different trading venues in order to achieve risk-free profits. Such traders are not only active in the crypto sector, but everywhere where possible and mostly with highly technical support.
First and foremost, we now want to understand why the ratio in the pool has changed at all and why this is also good. [As just indicated, the price of a coin on a DEX is not determined by order books, but by the ratio of coins in the pool. ] At the beginning there were 25 BTC and 1,000,000 DFI in the pool, which means nothing else than that, for example, 1,000,000 / 25 = 40,000 DFI / BTC applies. So, we're paying 40,000 DFI per bitcoin on the DEX. So we now know how the price on a DEX comes about in the first place. Now let's look at what exactly happened when the price of DFI doubled . To understand the whole thing better, we will now assume the point of view of an arbitrage trader . Trader X observes the prices and finds that you get 20,000 DFI per Bitcoin on central exchanges and 40,000 DFI per Bitcoin on DEX. He is happy and starts immediately. So he opens the DEX and buys 40,000 DFI with 1 BTC there, because the old price still prevails on the DEX. Then he sends the 40,000 DFI to a central exchange such as Bittrex and receives 2 BTC in return! He has now doubled his capital risk-free.
Since he's not stupid, he repeats the game and sends the 2 BTC back to the DEX. Now he realizes that with his first trade there are now 26 BTC and only 960,000 DFI in the pool. As we already know, the ratio of the coins on the DEX reflects the price. That means that Trader X has to buy for 960,000 DFI / 26 BTC = 36,923 DFI / BTC. So the price for DFI has risen, you now get only 36,923 DFI for 1 BTC on DEX instead of 40,000 as just now. Since this is still worth it, the trader exchanges his 2 BTC from just 2 * 36,923 = 73,846 DFI. He then sells it for 3.7 BTC and repeats the game. 15:00 He sends the 3.7 BTC to DEX and exchanges it for DFI.
But now, through his previous trades, there are 28 BTC in the pool and only 886,154 DFI in the pool. So the price is currently at 886154/28 = 31,648. He's now buying 117,097.6 DFI with his 3.7 BTC. In return, he receives 5.85488 BTC on the exchange. He repeats this over and over again and we see his trades as a table: 25 BTC 1,000,000 DFI -> price 40,000 DFI per BTC 26 BTC 960,000 DFI -> price 36,923 DFI per BTC 28 BTC 886154 DFI -> price 32,648 DFI per BTC 31.7 BTC 769056.4 DFI -> Price 24,260 DFI per BTC The whole thing will repeat itself until we receive a price of 20,000 DFI / BTC.
This is the case when we have around 34.5 BTC and 701.128DFI in the pool. This approximation is very imprecise. There are other important factors such as slippage and fees. In addition, Trader X would not be the only trader who would conduct arbitrage. But let's just assume this: then there are now 34.5 BTC and 701.128DFI in the pool and before that there were 25 BTC and 1,000,000 DFI in the pool Let's jump back to the point at which you noticed that you had more BTC and have less DFi than before and you had considered pulling some DFIs out of the pool to sell them. You now pay out and receive 20% from the pool. Why 20%? At the beginning of your investment, your share was 20% of the total pool size. These 20% are now 6.9 BTC and 140,225 DFI instead of 5 BTC and 200,000 DFI. So the ratio has shifted! Let's look at what this means for you in $: We previously assumed that BTC was $ 20,000 / BTC and DFI was $ 0.5 / DFI.
So the stake with 5 BTC and 200,000 DFI was $ 200,000. Now we have 6.9 BTC * $ 20,000 = $ 138,000 140,225 * $ 1 = $ 140,225 So you now have $ 278,225 instead of $ 200,000. Nice! But unfortunately you might have missed one thing: If you hadn't participated in the LM and just kept your coins, you would have 5 BTC and 200,000 DFI which are now worth $ 100,000 + $ 200,000 = $ 300,000. So you have now lost almost $ 21,775 by participating in the LM. How did that happen now? We noticed beforehand that the ratio in the pool has changed because Trader Y has carried out so-called arbitrage trading. Seen figuratively, the pool is robbed of a little of its value, which trader Y wins for himself and this loss is also your loss, since you own 20% of the pool ! Let's summarize the whole thing again in an understandable way: The fact that the price on a DEX is created by the ratio of the coins and there are no order books on a DEX creates the possibility that other traders can carry out arbitrage trading. As a result, the pool loses value, especially when the price makes huge leaps.
The ratio shifts and you get a different amount of coins used than the one you used. Arbitrage traders are nevertheless essential for a DEX, because otherwise the problem would very often be that one cannot trade at the current price. I really hope the explanation was understandable. Don't get demotivated if you haven't understood it yet and feel free to write me your questions in the comments. Before we end the video, let's take a look at how you can avoid IL. 1. Impermanent Loss, as the name suggests, is impermanent. In this example, it could have been that DFI fell back to the original price a few days later . If you would then have to pay out, you would not have suffered an impermanent loss as the ratio of the pool would have leveled off in your favor again.
2. You should always make sure that the price on the DEX is just balanced before you invest. Otherwise you run the risk that shortly after you invest the pool will be arbitrage and the ratio will shift. 3. Of course you get something back for your risk. At the current returns in the case of DFI (400% APY), the returns will far exceed the IL . Don't panic and take coins out of the LM, stay cool and enjoy the rewards. 4. Risks like the IL are one of my favorites. I can see exactly what is happening here and can simply work out what is going on ! Predictable risks are much more pleasant than unpredictable ones, no matter how high they are! There are some calculators and graphics on the Internet for the IL that will help you assess your risk.
For example, you can think of the following: If I expect BTC to remain stable at around $ 20,000 and DFI to rise less than 500%, I have to reckon with a maximum of 25% IL. If I get APY at 400%, that's almost 33% per month. So I have to take part in the LM for at least a month to cover the risk for this scenario. So you can think through many different scenarios. For now, this should be enough for this video. I would like to thank you very much if you have watched this video up to here and hope that you were able to take something with you. On this channel you will find much more detailed explanatory videos and tutorials about crypto currencies, their uses and risks in the future . I would be incredibly happy about a subscription and I wish you continued fun and success with investing and using cryptocurrencies..