Since the launch of decentralized exchanges (DEXs) with pioneers like Bancor and Uniswap and the rise of Decentralised Finance (DeFi) in summer 2020, owners of crypto assets can generate additional passive income by providing their funds as liquidity. But also term impermanent loss (IL) has been thrown around in every other discussion and scared off many people from acting as liquidity providers themselves.In this article, we want to explain the basic concept of providing liquidity and the risk of impermanent loss to you in an objective manner so that you can better understand how to provide liquidity to a decentralized exchange and what risks you are facing through IL.
Let us first clarify in which cases you might face impermanent loss. Most decentralized exchanges are automated market makers (AMMs). It is the most common form of a decentralized exchange first developed by Bancor where the asset price is not defined by an order book but a mathematical formula. The most used formula is “x * y = k”, where “x” is the amount of token 1 in the liquidity pool, and “y” is the amount of token 2 and “k” is a fixed constant, meaning the pool’s total liquidity always has to remain the same leading to pools consisting of the equal r… Read More