Tag Archives: decentralized finance

Steps To Avoid Impermanent loss – DeFi

If you’ve been involved with DeFi at all, you almost certainly heard this term thrown around. Impermanent loss happens when the price of your tokens changes compared to when you deposited them in the pool. The larger the change is, the bigger the loss.

DeFi protocols like Uniswap, SushiSwap, or PancakeSwap have seen an explosion of volume and liquidity. These liquidity protocols enable essentially anyone with funds to become a market maker and earn trading fees. Democratizing market-making has enabled a lot of frictionless economic activity in the crypto space.

What is Impermanent Loss?

Impermanent loss happens when you provide liquidity to a liquidity pool, and the price of your deposited assets changes compared to when you deposited them. The bigger this change is, the more you are exposed to impermanent loss. In this case, the loss means less dollar value at the time of withdrawal than at the time of deposit.

An Example of Impermanent Loss

Consider our example of depositing 50% ETH and 50% UNI on Uniswap. When the price of ETH increases, it creates an arbitrage opportunity to make a profit at the expense of liquidity providers. Let’s say the price of ETH grows by 5%, here arbitrageurs can buy ETH on Uniswap at a price 5% lesser than the external market. The decentralized exchange (DEX) then rewards them for selling UNI for ETH until the ratio of both tokens is equal. It leads to LPs losing out on a portion of their liquidity deposited to a specific pool.

How to avoid the impermanent loss

In a volatile marketplace, the impermanent loss is almost guaranteed when staking cryptocurrency assets within a standard liquidity pool. Exchange prices are always going to move. However, there are ways that the effects of impermanent loss can be mitigated.

Trading fees

Trading fees are collected from traders using the liquidity pool and a share of those fees are then rewarded to liquidity providers. These fees are sometimes enough to mitigate and offset any impermanent loss. The more trading fees collected, the less impermanent loss there will be. Past a certain point, if a pool collects enough fees an investor will have gained more from staking assets in a liquidity pool compared with holding them.

Low volatility pairs

Impermanent loss is likely to occur for the most volatile cryptocurrency pairings. However, the impermanent loss can be mitigated by choosing a cryptocurrency pairing where the exchange price is not volatile. Therefore, significant price movements between the pair are unlikely. If price volatility does not exist, the impermanent loss can be avoided.

Complex liquidity pools

One of the main reasons for impermanent loss is due to the 50:50 split that is required by most liquidity pools. To overcome this issue, some decentralized exchanges such as Balancer offer users a variety of liquidity pool ratios. They also offer pools with more than two digital assets. Price changes in pools that have a higher ratio, such as 80:20 or 98:2, do not result in as much impermanent loss when compared with pools that have a 50:50 split.

One-sided liquidity pools

Impermanent loss occurs in a standard liquidity pool where two different cryptocurrency assets must be deposited. However, some exchanges such as Bancor have developed liquidity pools that offer users the opportunity to stake only one side of the pool. The other side of each liquidity pool on Bancor is made up of the native Bancor token, BNT. 

Bancor has also recently integrated price feeds via the decentralized oracle, Chainlink. By tying liquidity pools with a live market price, they can automatically adjust when significant price changes occur. This is not possible in standard liquidity pools.

Other things you need to know about impermanent loss

While the basics of impermanent loss have been covered, there are a couple of extra details that are worth knowing before staking liquidity in DeFi protocols.

Impermanent loss can occur regardless of price direction. An investor can only withdraw digital assets that have not suffered an impermanent loss if the exchange price happens to be exactly the same at the time of withdrawal.

Secondly, an impermanent loss is only realized when funds are withdrawn. It is “impermanent” because prices could return to the initial exchange price at any time. If prices returned, the impermanent loss would no longer exist. The loss is only permanent if an investor withdraws their funds from the liquidity pool.

Bottom line


The incentives for liquidity providers in the DeFi sector are strong. However, they are strong for a reason. Each protocol needs to provide users comfort that they will not lose out to impermanent loss. While an impermanent loss is inevitable when staking liquidity in standard liquidity pools, there are alternatives that investors can use to mitigate the risk.

Those new to liquidity provision should stick with low volatile cryptocurrency pairings or stablecoin liquidity pools. Alternatively, investors can utilize some of the more complex liquidity pools to mitigate the impact. For the more advanced cryptocurrency user, yield farming techniques can be implemented to ensure returns always stay far ahead of impermanent losses.




Promise and the Current State of DeFi (Decentralized finance) – pros & Cons

Decentralized finance, or DeFi, has become a popular buzzword, especially with proponents of distributed ledger technology, blockchain, and cryptocurrency. Just as cryptocurrency was designed to ultimately take control of money away from governments, DeFi aims to take control of personal finance away from banks and investment firms.

What is DeFi?

Decentralized finance refers to a category of online financial platforms where one or more function is managed via smart contracts or other decentralized, blockchain-enabled, automated processes, rather than by a centralized system. However, as of this writing, there is no DeFi platform that is 100% truly decentralized. Each one still involves some degree of centralization in one or more aspects of its management.

The Current State of DeFi in 2021

Decentralized finance as we know it today is focused on one thing and that is to eliminate the middleman from financial transactions. As such, DeFi mainly relies on Ethereum as the blockchain that is easy to use and tailor according to the needs of a specific system.

What can a typical DeFi platform do today? The range of DeFi products varies significantly, but most systems guarantee the following functions:

1. Cryptocurrency exchange markets are free from central authorities
2. The ability to borrow or land digital coins
3. Near-instant payments from peer to peer
4. Advanced asset management through tokenization
5. The option of predicting asset fluctuations and capitalizing on your predictions

The Promise of Decentralized Finance

The aim of decentralization is to take control away from the establishment. Whether that establishment is a national government, regulators, or a centuries-old bank, proponents of decentralization see institutions as inherently corrupt and believe that people deserve greater freedom of how they store or spend their money. They also believe that the layers of bureaucracy slow things down to a pace that is not congruent with modern life, making it too difficult to send money across national borders or secure a loan to take advantage of a narrow window of opportunity.

The current bank customers may not even be the primary target audience for DeFi platforms. Many DeFi solutions are looking to engage with the unbanked or underbanked — people who currently have limited access to traditional financial services. This includes those in developing countries, rural areas, and people working in shadow economies.

Benefits of DeFi

Decentralized financial systems are not just a theoretical concept with little to no use, but rather highly practical inventions with tons of real-world benefits. Some of the major advantages of DeFi include:

  • The lack of centralized authority that monitors and controls financial transactions strictly. With DeFi, users’ deposits are free from external interventions.
  • Every participant in the DeFi system gains his own portion of financial sovereignty and democratic control. You know how the system works and you know that nothing can interfere with the process.
  • DeFi can reach the highest level of accessibility because, in theory, it only takes the Internet connection to gain access to the system regardless of your location.
  • Decentralization and the blockchain-powered platform make DeFi much safer and more difficult to penetrate by traditional hackers and malicious activities.

Cons of Decentralized Finance

Scalability 

DeFi projects encounter formidable difficulties in the scalability of host blockchain from various perspectives. First of all, the DeFi transactions require unbelievably extended periods of time for confirmation. 

At the same time, the transactions on DeFi protocols could become highly expensive during the period of congestion. For example, Ethereum could showcase capabilities for processing almost 13 transactions every second with Ethereum at full capacity. On the contrary, the centralized counterparts for DeFi could accommodate thousands of transactions in the concerned period.

Uncertainty      

The concerns of uncertainty also make a mark in the advantages and disadvantages of decentralized finance. In event of instability in a blockchain hosting a DeFi project, the project could automatically inherit instability from the host blockchain. As of now, the Ethereum blockchain is going through various changes. For instance, the mistakes committed during the transition from PoW consensus to the new Eth 2.0 PoS system can lead to risks. 

Shared Responsibility

The shared responsibility factor works negatively for users. The DeFi projects do not take responsibility for your mistakes. All they do is taking away the intermediaries, and it is the users who have to take responsibility for their funds and assets. Therefore, DeFi space needs tools that could prevent possibilities of human mistakes and errors.

Bottom line

Decentralized finance has become a promising favorite for transforming the conventional benchmarks of financial services. Most important of all, DeFi could foster the application of blockchain in the financial services sector. With the value benefits of transparency, immutability, and decentralization, DeFi space still has to encounter obstacles like scalability.  

About Decentralized Finance & Digital Gold – Cryptocurrency

Decentralized finance refers to financial activities conducted without the involvement of a traditional bank. Think about all of the activities in which you’d normally use a bank or some other financial institution — getting a loan, insurance, investing, even using a credit card. All of these activities are traditional-finance-based and have intermediary companies. Now people are creating these products in a completely autonomous way with cryptocurrencies.

It can seem counterintuitive — where else would you go for a loan, if not an established lender? But that’s one of the appeals to DeFi (Decentralized Finance). In the same way, people have increasingly brought smart technology into their homes, proponents say the cryptocurrency has the potential to automate and digitize more and more aspects of the financial system. The appeal of this happening outside the conventional — or centralized — finance system depends on who you ask. 

Many peoples may not understand the appeal of a finance system that operates beyond government control. But things can be very different in countries with less financial stability. If cryptocurrencies offer as much or more stability as a given national currency, it’s an entirely different equation than if your national currency is safe and stable.

There are different types of accounts and tools in conventional finance — from savings accounts to investment accounts to credit cards — that are used for different purposes, different cryptocurrencies can have similarly unique uses in this emerging decentralized finance system.

Instead of going to a bank to draw out a loan, you might go to a decentralized application that’s not owned or operated by anyone in particular.

Where conventional loans involve humans at a bank who take part in the processing, reviewing, and approving loans, a DeFi loan — with funding in the form of cryptocurrency — could run via an app on a network like Ethereum with an algorithm processing it. The borrower would put up some cryptocurrency as collateral, which they’d get back minus interest when they repay the loan.

The code runs autonomously using smart contracts. So once the developers release the data they’re pretty much hands-off, and everything runs automatically so there’s no intermediary.

Ethereum’s website offers a comparison chart contrasting decentralized from traditional finance. Along with these technical differences, a big consideration to keep in mind is that the conventional financial system is regulated to serve the interests of everyday customers, while cryptocurrency and decentralized financial systems are largely unregulated, and subject to governance and oversight only by their creators/users.

Unlike the money kept in a bank account, the money you have in crypto may not be FDIC insured. Some exchanges offer this insurance while others don’t — something you’ll want to look into before buying crypto from one or another. For exchanges that don’t offer this insurance, there’s no guarantee you will be repaid if there is a hack or the exchange goes out of business.

Decentralized FinanceTraditional Finance 
You hold your moneyMoney held by financial institutions 
Transfers happen in minutesPayments can take days to process
Transactions are pseudonymous Financial activity is coupled to your identity
Market is always openMarket closes 
Built on transparency – anyone can inspect the systemFinancial institutions are closed books

Digital Gold

Digital gold refers to cryptocurrency comparable to the real gold in its ability to store and increase in value. There’s a limited amount of gold on earth, in the same way, that digital gold cryptocurrencies have a limited supply. 

People buy gold not because they expect to be able to go to the store and spend it, but because they expect it to hold its value and maybe probably, increase in value over time.

The primary example of a digital gold cryptocurrency is Bitcoin, though that was not its original intention. Bitcoin was originally put forth as an electronic peer-to-peer cash system, but its volatility, among other things, limited its potential for that purpose. 

In use, such digital gold cryptocurrencies are bought and held for the same reason people would have diamonds, or some $100 bills, or some gold coins in a safe. Lite coin is another example — it’s been described as silver to Bitcoin’s gold.