Impermanent Loss Explained

With the rising popularity of yield farming, we really need to look at one of the biggest risks, the one risk that everyone needs to pay attention to, which is impermanent loss. It sounds really complicated, but at the end of the day, what happens is that if one of the coins drops rapidly in value, and we've seen this multiple times in this space, yield farmers and liquidity providers are sometimes left with just pennies in their accounts at the end, and that's something you definitely don't want to happen to you. And the worst part about yield farming becoming popular is that as it becomes more popular, there are more and more scams trying to steal money from yield farmers, and my intent for this video is really to just cover some of the risks and explain what impermanent loss is. So in the first part, we'll talk about impermanent loss, and the second part, we'll talk to some of the risks or some of the reasons why coins can drop rapidly in value as well. So these are the kind of the reasons for this impermanent loss. I know this kind of name sounds really complicated, but it's actually a concept that's very simple. Basically, if you're holding a coin and this coin drops rapidly in value, yikes, that's going to be something that's going to take a huge damage. Whilst this video is primarily geared towards yield farmers, it also applies to anyone providing liquidity to an asset. And if you don't have any idea what I'm talking about, there's a playlist right here. It's the decentralized finance playlist. I strongly recommend the video on balancer and uniswap for you guys to understand what's going on. Anyways, and of all these videos, it's not financial advice. It's my personal opinion. I'm not a financial advisor. You guys really need to do your research. We also have a t-shirt giveaway. So these are the anti-social crypto club and the box mining t-shirts. If you want to win one of these t-shirts, leave a comment down below. Hashtag notification squad. And this applies to all new videos released. And you must do this within the first 12 hours of the video launching. So the easiest way to get this done is obviously click that subscribe button down below and click that notification bell as well. All right, so let's get started. Let's get started with what the hell is impermanent loss. And I think the best way to really look at it is to look at which pools involve impermanent loss. So I'll just take a quick look. I'm not picking out projects in particular. But for example, we have projects like Sushi Party, which has a sushi to EVE pair. There's also this nice ring around it, trying to say that this is one of the kind of the higher yield pools. And a lot of people are lured by these numbers. For example, 1000% annual percentage yield. So four digits APY, that looks promising. And there's actually also a lot projects out there that offer even higher. I've seen five digit ones before and very, very tempting. And if you do the math, sometimes with five to six digit APYs, you can double up your money in a few hours. Some people think like that. But the problem is that the risks are also extremely insane for that too. Because you're actually not just holding the coin that you're mining. So this new coin, but also you're providing liquidity to it. So let's just start with an example of what impermanent loss means. Let's say for example, I have two $100 bills. All right, so I'm starting off with $200. And I'm going to go into one of these 5050 pools. So I'll start off by saying, I just buy $100 worth of this coin. We'll just call it gem. So I don't really, you know, piss off a particular project. Let's say I'm just buying this gem coin. So just for example, maybe this gem is worth 100 US dollars. And then we're pairing it with also 100 US dollars for the liquidity pool. That means we're starting off with one gem and then also paired with 100 USD for a total of $200. So starting off with $200. Now the risk comes when the gem prices start falling. A lot of times this happens because when a coin just starts, when a coin is new and it's just starting, well, prices can fluctuate a lot. And we've seen sudden price dips, which are not out of the ordinary. A lot of times, even if you look at a TA of a technical analysis of it, the support hasn't even been established yet. So the coin needs to find some sort of support. And it might take a nosedive if big sellers suddenly start selling that coin. So it's completely possible for this gem price to start off with 100, start off at 100, be okay at 100 and suddenly plummet just like a giant red arrow and drop all the way down to, let's say, 10 cents. That's entirely possible. And that's something that we've seen in this space. Now, if you were just holding these two coins, what you'll say is, okay, look, the gem is gone. Okay. Boom. Gone. Over. Game over. It's lost. It's now 10 cents. Pretty much write that off as a loss. But what about this $100 that you still had as USD? You'll be hoping that this is fine. But actually, because you're in and part of that liquidity pool, surprise, this is also gone. It's also, you know, maybe there. That is gone too. And that's the scariest part about impermanent loss is because a lot of people don't understand this. And when it comes to that surprise at the end, they're left with virtually nothing. So why is that? Well, it's because when these funds are placed in a liquidity pool, that is actually used to make the market. So that's used on the other side of the deal. So the easiest way to explain it is if someone wants to just sell massive number of coins, the liquidity pool is used to buy them up. So going back to our example, when the gem prices are plummeting here, so let's say it was plummeting, the liquidity pool, this $100 is actively being used to buy this entire dip. So throughout this whole time, you're actually accumulating more and more of this gem coin. So this is actually when you're exposed to a lot of danger and a lot of risks. So what happens towards the end, if this really does play out, you'll probably be left with maybe like 1000 gem, each of them worth nothing, and maybe one US dollar at the end. So it's actually a total obliteration of the funds you kind of started off with. And that's impermanent loss. Now, if you want to get mathematical, there's actually a few good charts on this explaining on permanent loss and what's going on. So say, for example, this is the chart on Bancor Network, and this applies to 5050 pools. Now, what happens is just using our example, if it starts off as this was the price of gems starting off with $100 per gem, if the gem prices just decrease drastically, you'll see you'll suffer huge losses once it drops past roughly, let's say, around $20, you'll see your impermanent loss just stacking, stacking up and up and up. So this is when, you know, when it's provided $5 for that gem or $1 for that gem, you're going to start losing your entire stash. So these are great charts, and I will recommend you checking them out. I'll have a link down below. And there's multiple different charts. So some charts for this 5050, and also this chart, which has the balancer 98 slash two as well. And this is a very, very popular pool. So even with something like this, just reading off the orange line here, you can see that even with a 2% exposure of the 98 and 2% pools, you can suffer impermanent loss. And it does really stack up when one of the coins drops by 85% or above. So when you're dropping above 85%, your impermanent loss starts stacking. And when you're reaching around 95% drop in one of the prices of the coins, you can start losing pretty much everything. So this is pretty real, it does happen, and we have to watch shout for it. Now you might say, oh, 90% drops, this is very, very rare, hardly happens. But actually, it happens quite a lot more when it comes to yield farming and new projects. I don't want to say every project is super volatile. I think there are some really good yield farming projects out there. But I wanted to make this video more about the risk side. And there are some unfortunate malicious developers who target yield farmers and the greed of yield farmers too. So in that respect, what is the number one scam out there or the developer pull rug? So some developers are malicious. And what they do is they leave the possibility of creating infinite coins, right? This magic called mentor address, this magic Thanos snap that can create trillions of coins out of thin air. This can absolutely happen if the developer left a back door. And a lot of times we're just trying to figure out and scan for that back door. So if there is such a back door and a developer creates infinite coins, they can crash the price and just obliterate the market. They can just dump all those coins, trillions and trillions upon trillions of coins into the market and obliterate the price. And that's has that's happened before. And that's something that I try to actively look out for. But when it comes to yield farming, when you're doing your due diligence, sometimes it gets passed. And this is why we really need professional auditors to look at it to make sure to ensure that there is no loophole that developers can use to create infinite coins. Ideas of auditors like Hacken or Quantstamp or Trailbits become very, very important. Now, there's also a second reason why this is quite present in yield farming. And that's because initially, when a coin is launched, the supply is very, very low. So it's very easy for a group of people, either the developers themselves, or one or two particular whales, to accumulate a lot of this coin. This means that the supply is extremely, extremely choked, leaving to very fast, rapid rise in the value of a particular asset. Now, the biggest problem is, is that if these whales decide to cash out, they can just dump it at a snap of a finger, also creating this giant downward arrow. And to make matters worse, when this starts happening, let's say when this dump occurs, like here, what happens is that people also freak out, miners start freaking out, and they also start dumping. So it's almost like a chain reaction. And it's like a spiral of death. Happens quite a few times, I've seen it firsthand, and a price just goes down and down and down. And that also causes huge impermanent loss as well. So it might even not be intentional. And even if you scan for the code, you'll probably realize that there's no way for the developer to create infinite mint, but it's rather market forces that's causing a gigantic dump and causing farmers to lose out. So anyways, that's kind of the two main causes of impermanent loss. Obviously, it does get better over time, as a project has more and more coins out, and for the kind of supports the form on a particular coin. So that does make things quite a lot better. So this is why over time for projects that have been around for longer, I'm a little bit more okay going into these liquidity pools. But if it's new, I'm very, very cautious. And unfortunately, in this space, there's this huge kind of gambler's mentality of people going forward, going first, but not always succeeding. Anyways, that's my kind of quick recap of impermanent loss. I hope you guys understood it. If you guys want to read more, I'll have articles down below and all those charts and stuff that kind of explains everything else on there. If this is very foreign to you, and you kind of want to understand a little bit more of automated market making, I think this is something that's core to understanding this video, then check out the guide, the whole playlist over here on decentralized finance, and that'll get you up to speed with everything in this video. And with that, guys, thank you guys so much for watching this video. Remember to click the like and subscribe button. And if you want to win a free t-shirt, make sure you type hashtag notification squad down on the comment section below. Thanks so much for watching. See you in the next video.