Understanding the Risks of Impermanent Loss
When providing liquidity to a decentralized exchange like PancakeSwap, you run the risk of impermanent loss. This concept is harder to understand but we're going to break it down step by step to help you fully understand the risks you accept by providing liquidity.
Simply put, impermanent loss is where a liquidity provider (LP) would have a higher value of tokens if they had not provided liquidity. However, the LP still holds the amount of LP tokens that could return in value. This is where the "impermanent" part comes in. The loss only becomes permanent if the LP sells their LP tokens to redeem the underlying assets.
Step 1. You provide liquidity to PancakeSwap for CoolCoin (a made-up token) and USDC (a stablecoin always worth $1). Because CoolCoin is worth exactly $100 at that time, you add liquidity by staking 1 CoolCoin and 100 USDC.
In our example, we'll say that your stake makes up 10% of the entire CoolCoin-USDC pool (meaning there are 10 CoolCoin and 1000 USDC in the entire pool). The overall value of your 10% share in the pool is $200 (1 CoolCoin worth $100 + 100 USDC worth $100).
Step 2. People swap between CoolCoin and USDC and pay a small fee in the process. Because you own 10% of the assets in the CoolCoin-USDC LP pool, you receive 10% of each trading fee. As time passes, you earn rewards for providing liquidity from those fees.
While the price of CoolCoin fluctuates, the fees you collect (ideally) cover the small loss. For simplicity's sake, we are not going to factor in this profit made from trading fees since it is dependant on the number of trades being done.
Step 3. CoolCoin dramatically rises in value to $400 per token. Though the price has changed, you still own 10% of the assets in that pool. The pool now has 5 CoolCoin in it and 2000 USDC.
Your 10% ownership of the pool is now worth $400 (0.5 CoolCoin worth $200 and 200 USDC worth $200). If you were to withdraw your liquidity, you would've gained $300 in the process. But, you would've made more if you had simply held. Your 1 CoolCoin and 100 USDC would've now been worth $500 total with the new prices.
While this example utilizes a somewhat extreme price jump, low market cap cryptocurrencies tend to be extremely volatile and a 4x price jump is not that rare of an occurrence. Making profit through providing liquidity is dependant on the trading fees you earn to cover the relative loss and still have extra left over as profit.
Vaulty dramatically lowers this risk by allowing liquidity providers to stake their LP tokens and earn more $VLTY. This bonus gives LPs even more profit and dramatically lowers the risk of impermanent loss.
At the end of the day, impermanent loss is a risk that you should carefully consider before providing liquidity. Just like any other investment, liquidity providing is a risk. Vaulty can not guarantee that you will end up profitable.