How to Avoid Impermanent Loss When Providing Liquidity in DeFi

A relatively popular sector in decentralized finance (DeFi) is liquidity mining, which is how users place their cryptocurrencies into liquidity pools on automated market maker (AMM) decentralized exchanges (DEXs). In return, liquidity providers (LPs) earn rewards for increasing the liquidity available in these DEXs for market participants to swap.

These AMM DEXs utilize algorithms that drive the token rebalancing formula for the pools, allowing for sustainable swapping. However, using such algorithms result in divergence between the new price of the cryptocurrency in the liquidity pool and the original price at which LPs have deposited it. This difference in price is known as impermanent loss, and becomes greater when the change in price is larger.

In this guide, we’ll discuss impermanent loss, the pros and cons involved in providing liquidity, and how you can avoid or minimize your level of impermanent loss.