Before the emergence of decentralized finance, cryptocurrency was stored in either exchange markets or on hardware wallets. Though both methods are much safer than online wallets, they give traders fewer options for trading strategies.
They were bound to use either day trading or Hodling. It restricted the part-time traders as they couldn’t participate in short-term trading. Long-term trading is beneficial only if you have been in the market for a while. To solve this problem, decentralized finance came into being. This way, traders could keep their money in online crypto wallets and perform various trading strategies.
Decentralized Finance & Its Impact
DeFi lets users earn passive income by keeping their assets as liquidity on lending protocols, decentralized exchanges, and other platforms. It made the increment of one’s capital possible by sharing it with newly introduced trading platforms.
Exchanges built on the Automated Market Makers model require traders’ liquidity to keep the currency going. If this doesn’t happen, the exchange cannot cater to its traders who want to exchange tokens. As a result, organizations are significantly incentivized to compensate people who provide liquidity by distributing trading fees later in exchange for their preceding effort.
It is a method in which cryptocurrency traders loan their assets to decentralized exchanges to receive rewards. These benefits are usually derived from trading fees incurred by traders switching tokens. The fee per exchange is 0.3%, and the final reward varies on the person’s share in a liquidity pool.
If we take Uniswap’s case, for instance, crypto traders will give equal shares of tokens (in terms of their value). For 7 ETH tokens, each priced at $1200, we will receive a total of $8,400. So, to lend 7 Ethereum coins, we have to give them 8,400 USDT (with a value of $1 per token).
The liquidity from Uniswap will be given to clients who trade through ETH/USDT (among others) liquidity pool. The fees are then summed up and distributed among the liquidity providers.
It is the opportunity cost of keeping or hodling an asset for the purpose of speculation in contrast to giving it as liquidity to receive the fees. As the Bitcoin system is volatile, it is relatively easy to avoid IL.
If an asset in the user’s preferred LP declines or acquires too much value after being invested, the user risks not profiting or perhaps incurring losses. For example, Ethereum’s value can quadruple in 8 days, yet the fees awarded for mining it does not compare to what would have been made by HODLing.
The term “impermanent loss” is well-deserved. Losses are only recognized when the user withdraws his liquidity. But if the market recovers to its previous price, it is feasible to avoid IL. In any case, if this does not occur, LPs must cash out their liquidity and find ways to recover their impermanent loss.
Cryptocurrency developers are always looking for ways to make this trading easier for their users. They are trying to reduce the adverse environmental effects caused by mining, introducing new cryptocurrency wallets, and including new strategies for beginners. You just have to learn how to use the market fluctuations to your advantage, which will become a game changer.