What is an impermanent loss in yield farming?
When a token price rises or falls after you deposit it in a liquidity pool, this is known as crypto liquidity pools’ impermanent loss (IL).
Yield farming, in which you lend your tokens to gain rewards, is directly related to impermanent loss. However, it is not the same as staking, as investors are required to inject money into the blockchain to validate transactions and blocks to earn staking rewards.
On the contrary, yield farming entails lending your tokens to a liquidity pool or providing liquidity. Depending on the protocol, the rewards vary. While yield farming is more profitable than holding, offering liquidity has its risks, including liquidation, control and price risks.
The number of liquidity providers and tokens in the liquidity pool defines the risk level of impermanent loss. The token is coupled with another token, usually a stablecoin such as Tether (USDT) and an Ethereum-based token like Ether (ETH). Pools with assets like stablecoins within a narrow price range will be less vulnerable to temporary losses. As a result, liquidity providers face a lower risk of impermanent loss with stablecoin in this scenario.
So, since liquidity providers on automated market makers (AMMs) are vulnerable to future losses, why do they continue to provide liquidity? It is because trading fees might compensate for the temporary loss. For instance, pools on Uniswap, which are highly susceptible to temporary loss, can be profitable due to trading fees (0.3%).