What is liquidity pool?
Crypto is a game-changer, and traditional finance are actively moving towards the crypto sector. DeFi, also known as Decentralised Finance, usually refers to all crypto-financial activities on blockchains. The DeFi sector has been a strong growth driver for the crypto market and is expected to take over the traditional financial sectors.
Apart from the crypto versions of traditional financial activities such as borrowing, staking, and lending, DeFi sees an increasing number of new crypto inventions such as Liquidity Pool. A crypto treasury based on smart contracts, a liquidity pool allows users to conduct financial activities in a permissionless way and get rewards in crypto. Decentralised crypto market leaders including Bancor and Uniswap tend to encourage DeFi users to provide liquidity for their markets through AMM, Automated Market Makers, an algorithm that enables automated crypto trading.
Liquidity pools equipped with AMMs usually consist of different trading pairs of tokens. For example, a pool can be created to provide liquidity of a pair of DAI/ETH while liquidity providers will transfer assets from their wallets and inject them to earn profits in crypto. Providers will earn a slice of the transaction fees for every successful transaction in the pool according to a certain ratio of their own contributed liquidities.
What is impermanent loss in DeFi?
Liquidity pool is essential to the DeFi industry as it guarantees stability to a market that is highly fluctuating in price. Given the heating competition of different DeFi protocols, more and more platforms are trying to attract liquidity providers through rewarding native governance tokens. Liquidity mining, also known as yield farming, has consequently become more popular as users are happy to get those tokens as passive incomes after transferring and staking assets to different liquidity pools.
Higher yield comes with higher risks. Liquidity providers have to deal with risks including bugs in the smart contract, rug-pull scam, and impermanent loss, which generally refers to a price gap between token pairs ratio in the pool and the ones currently in your wallet. The price gap is temporary due to ever-changing crypto price, making the loss impermanent.
What are the possible implications of impermanent loss?
Implications of impermanent loss, however, can be permanent. If you withdraw the liquidity pair when the value of tokens is down, you suffer a loss permanently. It is extremely important to choose your own denominated currency, for example, stable coins such as USDC or mainstream assets like ETH, when setting up a trading pair of tokens at the right ratio in a liquidity pool. How to minimise the loss is equivalently crucial to max the profit.
As for crypto investors in Australia, tax concerns are part of the implications. A leading country in crypto regulation, Australia has promulgated detailed and comprehensive laws to tax crypto investors. As stated by Australia Tax Office, ATO, crypto profits resulting from lending, staking or other DeFi activities are taxable and fall under the category of income tax. A net capital loss in crypto investment can be used to offset capital gains in future tax years. In the case of an impermanent loss turning into a real and permanent one, you may want to use it to offset tax in Australian dollars for future gains.
