Risks and Impermanence
The major risk that a user takes on board by holding a swap liquidity pool token (that is, the LP we just discussed), is called Impermanent Risk. Here, we will try to give a basic introduction to impermanent risk, and provide an introductory discussion to how it can be used effectively in a portfolio. Nothing discussed herein is financial advice, it is merely a description of liquidity pools and impermanent risk. Please consider your own circumstances before making any financial decisions.
When a user deposits funds into a liquidity pool, they are providing two tokens (let’s call them ADA and VYFI) to a contract. These tokens are deposited at a ratio that is determined by their price. As an example, if 1 VYFI = 1 ADA, then the deposit ratio would be 1VYFI:1ADA. In this above example, let’s say a user deposits 100 ADA and 100 VYFI into the liquidity pool to allow users to swap between them. Imagine the price of VYFI starts doing well, and goes up. What does this mean from a mechanical perspective? It means users are trading ADA in exchange for VYFI. This means the liquidity pool is having VYFI withdrawn, and ADA deposited. After a period of time, the price of VYFI has increased, and is now 1 VYFI = 1.5 ADA. The user who originally deposited 100 VYFI and 100ADA will now hold 80 VYFI and 120 ADA in the liquidity pool. This has meant an effective LOSS of 20 VYFI and an effective GAIN of 20 ADA for the user. The same holds true in reverse. If the price of VYFI where to go down, the user would GAIN VYFI, and LOOSE ADA. I have made a general chart, labeled image 1. The liquidity pool will gain whichever token is losing value the fastest. And this is the definition of impermanent risk. All liquidity pools will gain the lower value token, and lose the higher value token.
From the moment you enter a pool, you begin earning fees. But at the moment you enter, you have earnt $0 in fees. It is at this point that you are at the highest risk. As you earn fees your liquidity builds and thus, your exposure to impermanent risk decreases over time. In general, the more volatile an asset, the higher impermanent risk you will experience.
Impermanent risk is the tendency for liquidity pools to gain whichever token is losing the most value. As a holder of an LP token then, it is important to be aware of this risk, and to ensure that you manage your position appropriately. Many platforms offer a return for holding their LP (called Liquidity Mining), to pay-out users for holding this risk. Make sure you never risk more than you can afford to lose in trading.