Investing Archives | Page 209 of 221

Aug

2021

Blockchain in Insurance: Evaluating the Pros & Cons

By Brian Nibley | Growing Wealth, invest, Investing | Comments Off

Blockchain, the technology that powers cryptocurrency, has several other use cases, including the ability to facilitate financial agreements and contracts quickly and transparently. That makes blockchain a particularly interesting technology for the insurance industry, which revolves around the creation and execution of financial contracts.

Blockchain 101: The Basics

Blockchain technology is the technology allows users to hold and transfer Bitcoin and other cryptocurrencies. A person or group known as Satoshi Nakamoto invented blockchain technology in 2009.

Blockchains are a specific type of distributed ledger technology (DLT). While all blockchains are distributed ledgers, not all distributed ledgers are blockchains.

Distributed ledgers keep records of transactions or other information throughout different computers in different locations. A blockchain is a special type of distributed ledger that developers created to be immutable (can’t be changed) and decentralized (can’t be centrally controlled).

A blockchain works by processing transactions into groups referred to as “blocks.” Each new block gets attached to the block that came before it, creating an ever-growing chain of blocks. This is where the term “blockchain” comes from. Altering the data inside any single block would require changing the entire chain, something almost impossible to do in most cases.

However, the data held in blocks can take many forms, not just financial transactions. The ability to create an immutable, transparent, decentralized ledger of data without a single point of failure means there are many potential applications of blockchain.

Recommended: A Guide to Blockchain Technology

How Does Blockchain Help Insurance?

There are a number of key ways that insurance blockchain could benefit the industry:

Enhanced efficiency

With so many time-consuming manual processes with the potential for human error, blockchain can streamline the processing of insurance contracts.

Trust and transparency

The encrypted nature of blockchains mean that transactions can be trusted as secure and authentic, which both ensures customer privacy and leads to less confusion.

Claims processing

Real-time data collection and analysis become possible with blockchain, bringing with it the potential to speed up claims processing and payouts.

Smart contracts

These virtual contracts can be programmed to automatically execute when certain conditions are met. These could be used to create insurance policies that are cheaper to administer and also cost less for customers.

Insurance fraud

People often falsify information in claims for casualty and property insurance, costing the industry more than $40 billion per year. The way the insurance industry conducts business today leaves room for error and increases the risk of fraud. If insurance companies were able to store information about their claims on a blockchain, this could help them more easily identify suspicious behavior.

Block chain could reduce such fraud by introducing:

• Automated claims via smart contracts

• Automated insurance claim payouts

• Authentication for documentation, lowering the risk of fraud

• Creating a permanent record of all transactions

Drawbacks to Blockchain in Insurance

Introducing Blockchain to insurance also has some potential downsides. While decentralization makes a blockchain more secure by eliminating any single point of failure, it can be difficult to maintain. When a single organization creates its own blockchain for specific purposes, the computers that run the network (referred to as nodes) could wind up becoming centralized, leading to the destruction of one of the key benefits of blockchain.

There could also be a problem with trust. With the Bitcoin blockchain, people may trust the transaction data because from the moment they’re mined, users can see where coins go, at what time they moved, what crypto wallets they’re in and what crypto wallets they used to be in. all of this information is transparent, provided that the asset being tracked is native to that blockchain.

Most of the potential use cases for blockchain involve assets that didn’t originate on-chain (like insurance claims) but were first created somewhere else. For this reason, it’s possible that the data being put onto a blockchain could be inaccurate. And if the blockchain truly is immutable, those inaccuracies might be impossible to fix.

Potential Blockchain Use Cases in Insurance

Blockchain for insurance could create many advantages for the industry. The potential benefits mostly stem from the universal features of blockchains, like immutability, blockchain security, and transparency (or privacy, if that’s what’s required). There are several ways that insurers could put this to use:

Health Insurance

One potential area of use for blockchain is in health insurance. Insurers currently keep health records on their own systems, and transmitting that information from one provider to another can be inefficient.

However, blockchain could make it possible to conduct faster and more accurate sharing of medical data between insurers and healthcare providers in a way that is private and secure. This could result in health insurance claims being processed faster and customers paying lower premiums for their coverage.

Property Insurance

Property insurance and casualty insurance includes home, commercial, and auto insurance. The dollar amount of premiums written for this type of insurance was more than $638 billion in 2019. Introducing smart contracts could make claims processing more accurate and efficient. Smart contracts execute themselves automatically when certain network conditions are met.

For example, a smart contract for auto insurance could automatically execute and trigger a payment after a car accident.

Travel Insurance

Delayed flights and other unexpected travel interruptions can create headaches for everyone involved. People who hold travel insurance policies have to go through a long and arduous process just to file a claim. Blockchain can make the whole process smoother and faster, allowing customers to automatically get paid for events like flight delays and receive payouts immediately.

Title Insurance

Title insurance is intended to make up for losses created due to mistakes in titles or similar legal documents. Title insurance underwriters often share information about their policies between themselves. A blockchain-based platform could allow underwriters to easily see previous title insurance policies automatically. This could not only speed up real estate transactions, but also reduce potential fraud due to the transparent and immutable nature of blockchain.

What Companies Use Insurance in Blockchain?

Some companies throughout the world have already begun implementing blockchain technology in insurance for their day-to-day activities. While decentralized finance (DeFi) is revolutionizing financial services, blockchain is being used by some existing insurance companies to improve their existing practices.

Blue Cross

Blue Cross, based in Hong Kong, uses blockchain to prevent fraud and accelerate the processing of insurance claims. The platform verifies data in real time and gets rid of the need to reconcile claims data between different parties like insurers and healthcare providers.

Lemonade

Lemonade, based in New York, is a company that combines artificial intelligence and blockchain to offer insurance to homeowners and renters. Lemonade uses smart contracts to instantly verify losses when a customer makes a claim. If a claim gets approved, the AI and blockchain system makes payment immediately.

FidentiaX

FidentiaX, based in Singapore, is a marketplace for tradeable insurance policies. Users have the ability to buy and sell their policies on a blockchain. Users can buy insurance policies from others and access all relevant data in a single location. The company developed something called ISLEY, which lets customers get detailed overviews of policies, receive notifications about premiums, and see records of their history.

IBM

IBM is making its blockchain available to insurers, streamlining recordkeeping and allowing for instant updates after transactions. The company claims that users also reduce management costs and enhance customer satisfaction.

Allianz

The insurer is testing a blockchain-powered platform for its commercial insurance business that would allow for faster and more secure police and claims management.

Universal Fire & Casualty Insurance

This small business insurer has begun accepting crypto as a method of premium payments.

MetroMile

This pay-as-you-drive car insurer is not only accepting crypto for premium payments but also using it to pay out claims.

The Takeaway

The blockchain has many uses outside of sending cryptocurrency, and the insurance industry could likely benefit from many of those uses.

Photo credit: iStock/blackCAT

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Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments. Limitations apply to trading certain crypto assets and may not be available to residents of all states.

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Aug

2021

SegWit: Definition & How it Works

By Matthew Zeitlin | Growing Wealth, invest, Investing, Terminology | Comments Off

SegWit is an update to Bitcoin’s protocol that changed the way that the blockchain transfers information. Protocols are the rules that govern the way that Bitcoin and other cryptocurrencies work.

What Is SegWit?

SegWit is an example of the Bitcoin development community being able to solve a problem while still maintaining the integrity of the Bitcoin protocol and blockchain.

SegWit stands for “segregated witness,” and it’s a key turning point in the history of Bitcoin and cryptocurrency, and represents a fork in the road, or at least a fork in Bitcoin. The SegWit fork changed the rules, allowing for larger blocks and removing signature data from Bitcoin transactions.

How Does SegWit Work?

SegWit removes (or segregates) the signature (or witness) from the block, moving it instead to the back of the transaction. This frees up more space for the transaction itself.

What Problems Does SegWit Solve?

SegWit solves several issues with earlier versions of the Bitcoin protocol.

The Transactions Problem

The original Bitcoin protocol limits the size of “blocks” to a single megabyte. The whole Bitcoin network “confirms” a new block every ten minutes, with a few transactions taking place every second. These blocks and the confirmation process comprise the foundation of Bitcoin.

As Bitcoin scaled and got bigger and more miners, developers, and users became part of the Bitcoin community, a debate arose around the size of blocks. Should it increase beyond founder Satoshi Nakamoto’s original vision or stay the same?

If the community decided to make an increase, it would have to receive approval by consensus, or perhaps risk splitting Bitcoin apart into separate protocols.

The Malleability Problem

The Blockchain also had some security and efficiency issues, known as “malleability.” Prior to Segwit, every Bitcoin transaction included a “signature” that became part of the transaction confirmation. The signature, with the use of a private key, would become part of the block transfer, taking up space that could have been more Bitcoin transactions. Another word for these signatures is “witness,” and so was born the idea of Segregated Witness, or SegWit.

The theory behind SegWit held that Bitcoin transactions could be more efficient, more secure, and better recorded on the Blockchain itself. This would also allow for developers to build transfer improvements on top of the original Bitcoin protocol, leading to the development of the Lightning Network.

The Scalability Problem

One of the major issues addressed by SegWit was the so-called “scalability problem,” which refers to the issue with block sizes that can limit the speed and scale of transactions on a Blockchain network.

When Was SegWit Created?

The Bitcoin Segwit update took place on August 23, 2017 and changed the way information was transferred on the blockchain.

Prominent Bitcoin developer Pieter Wuille originally proposed the update in 2015 as a way to address a problem in the less-than-a-decade-old protocol that governed the cryptocurrency. He and others believed that transactions took too long to process and that they had some security issues.

There were two ways, known as forks, to address the problem.

A hard fork

A hard fork creates a new system all together. Bitcoin Cash is an example of a hard fork, which enabled large block sizes, but ultimately created a new network.

A soft fork

With a soft fork, the new system works with the old one. This is the option that developers used for SegWit, which became one of the most prominent and important Bitcoin forks. In the dispute between soft fork vs hard fork, SegWit’s successful adoption is a victory for the soft forks.

What Was Segwit2x?

Some prominent Bitcoin miners supported several approaches to the scale issue inherent in the original Bitcoin protocol. To move forward, they came to what’s known as the “New York Agreement,” a plan to implement SegWit and do a hard fork of Bitcoin to increase the block size limit. This was “SegWit2X.”

However, Bitcoin’s developers didn’t endorse the plan and it never reached the consensus necessary for a successful hard fork. These developers have huge sway over the greater Bitcoin community and without their support, a fork wouldn’t have enough takers to challenge Bitcoin in its present set-up. By late 2017, SegWit2X had collapsed and early the next year, SegWit was fully operational on consumer cryptocurrency platforms like Coinbase. And major crypto wallets, the hardware and software products that allow for safe crypto storage, had signed on to the SegWit update.

The failure of SegWit2x shows that even large Bitcoin mining pools, groups of miners that run the hardware that creates new Bitcoin, don’t have total sway over the Bitcoin community and can’t singlehandedly dictate its direction – or its forks. Bitcoin miners have tended to prefer Bitcoin changes that would increase the block size as opposed to segregating out signatures, since that would bolster the fees they get from the network for processing blocks. But the Bitcoin community is more than just its miners, and so their opinion only means so much.

Should You Use SegWit?

While the Bitcoin scalability debate is hardly over, for the time being, Bitcoin itself remains in the driver’s seat in terms of usage and developer activity compared to its rivals and hard forks.

By early last year, at least two thirds of transactions used SegWit, indicating that the soft fork “works” for many in the Bitcoin community. By the end of 2020, one of the last exchanges to hold out, Binance, announced that it would support SegWit.

There are several benefits to using Segwit for crypto transactions, including lower transaction fees and faster transactions.

The Takeaway

SegWit was a major upgrade to the Bitcoin protocol, and one that has helped accelerate widespread adoption of the cryptocurrency in recent years.

Photo credit: iStock/BartekSzewczyk

Aug

2021

Guide to Eco-Friendly Cryptocurrencies

By Laurel Tincher | Growing Wealth, invest, Investing | Comments Off

Although there are many benefits to Bitcoin, the cryptocurrency has come under scrutiny due to the significant electricity use involved in mining and keeping the blockchain network running. This issue is one of the reasons Bitcoin has not become more widely adopted than it has so far.

Bitcoin miners globally use thousands of computers to solve complex algorithms in order to mine new bitcoins and verify transactions. This computational work keeps Bitcoin decentralized, secure, and available for use 24/7, but it also has a relatively large carbon footprint. However, not all digital currencies use as much electricity as Bitcoin, and there are ways that Bitcoin can be made into a more eco-friendly cryptocurrency as well.

The crypto industry recognizes Bitcoin’s electricity use, and is taking steps to reduce it. Some crypto miners use renewable energy sources in an effort to keep their costs down. The Bitcoin Mining Council claims that more than half of Bitcoin mining uses sustainable electricity, but some scientists have found that the Bitcoin network could consume nearly as much electricity as all global data centers combined.

Still, leaders in the crypto industry signed the “Crypto Climate Accord ,” an agreement to power 100% of global blockchains by renewables by 2025.

Why Does Bitcoin Require So Much Energy?

Bitcoin requires so much electricity because it uses a “proof-of-work” system that requires “work” using computing power in order to keep it running. The proof-of-work system essentially uses the proof of work as a way of validating transactions, mining new bitcoins, and keeping the blockchain working.

In addition to using more renewable energy for Bitcoin mining, there are other ways that Bitcoin can reduce its energy use in the coming years, such as the introduction of the lightning network, cloud mining, and off-chain transactions. But for now, Bitcoin’s electricity use continues to be high.

Recommended: How Much Energy Does Bitcoin Use?

12 Most Sustainable Cryptocurrencies

Are any cryptocurrencies eco-friendly? Yes, there are other types of cryptocurrencies and proof systems that don’t use as much electricity. These include “proof-of-stake (PoS),” “proof-of-storage,” and “proof-of-space.” Rather than relying on energy-intensive work, these proof systems use other types of verification and incentive structures. Even among proof-of-work cryptocurrencies, some are more energy-efficient than others, depending on the type of devices used for mining and the way the algorithm works.

There are alternative cryptocurrencies, or altcoins, that use far less electricity than Bitcoin. Some coins simply have fewer transactions, while others are actually designed in ways that are more energy efficient. Some popular cryptocurrencies that may be more eco-friendly than Bitcoin include:

1. Ethereum (ETH)

Ethereum is in the process of switching over to a PoS model, which will drastically cut its electricity use.

2. Nano

Nano is very energy efficient because it doesn’t even use mining, it uses a different form of proof-of-work system. It offers instant transactions with zero fees.

3. Chia (XCH)

Touted as one of the most eco-friendly cryptocurrencies, Chia uses a unique “proof of space and time” model that utilizes storage space on users’ personal computers to keep its network running. It creates “plots” of numbers, which it “farms” over time. Bram Cohen, the creator of BitTorrent, created Chia. The coin’s only environmental downside is that it requires the use of solid-state drives, burning through them quickly and creating a lot of e-waste.

4. Stellar Lumens (XLM)

A popular cryptocurrency that uses a small amount of electricity, Steller has a unique consensus model that uses nodes instead of a proof algorithm. It is a network created to be a bridge between cryptocurrencies and traditional financial institutions, similar to PayPal. Users like Stellar because it is fast, simple, and cost-effective for sending large transactions all over the world across any currency.

5. Polkadot (DOT)

Another Ethereum co-founder, Gavin Wood, created Polkadot, which uses a multi-chain network to go between different blockchains. It uses a nominated proof-of-stake (NPoS) model that requires holding or staking coins in the network instead of a mining process that would use more electricity.

6. Hedera Hashgraph (HBAR)

Like Nano, HBAR doesn’t use mining, and has quick, low-fee transactions. Large corporations such as Google, Boeing, and IBM support this cryptocurrency, which is used for micropayments and transaction fees.

7. Holo (HOT)

Holochain doesn’t use mining or much electricity, and it is scalable and less expensive than many other cryptos. Instead of a proof system, the cryptocurrency enables users to earn “HoloFuel” in exchange for sharing computing power and space on their personal computers to host peer-to-peer (P2P) apps on the network. This creates a very large network that can scale over time without centralization or huge increases in energy use.

8. Ripple (XRP)

Another popular cryptocurrency designed to use less electricity than Bitcoin, Ripple has its own calculator which determines the environmental impact of events and assets on its blockchain network.

Recommended: What Is Ripple (XRP)? How Does It Work?

9. IOTA

Iota doesn’t use mining, but instead uses a network of smaller devices that use less electricity.

10. Solarcoin (SLR)

This unique eco-friendly cryptocurrency promotes the creation and use of solar energy. Users who create solar energy are rewarded with Solar coins.

11. Bitgreen (BITG)

Similar to Solarcoin, Bitgreen rewards users for eco-friendly activities such as volunteering or carpooling.

12. EOSIO (EOS)

Another eco-friendly cryptocurrency. EOS uses proof-of-stake along with pre-mined tokens, rather than energy-intensive mining. Users like this crypto because it is very easy for developers to use, is low cost and highly scalable.

The Takeaway

Crypto evangelists may appreciate the many benefits of investing in digital assets, but worry about the impact on the environment and question whether blockchain is environmentally friendly. However, there are many other cryptocurrencies besides Bitcoin, many of which have a much smaller carbon footprint, and may make sense as one type of investment in a diversified portfolio.

Photo credit: iStock/MicroStockHub

Aug

2021

What is a Crypto Bear Market?

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

Since Bitcoin’s launch in 2009, several crypto crashes have occurred, including some that have completely wiped out specific altcoins. Since those crashes happened in lesser-known forms of crypto or without extensive media coverage, not all investors are aware of them.

Despite the crashes, however, there haven’t been any sustained bear markets in Bitcoin, which is the de facto benchmark for cryptocurrencies.

What Is a Crypto Bear Market?

A crypto bear market is one in which the value of major cryptocurrencies, such as Bitcoin, have fallen at least 20% from their recent highs, and are continuing to fall. By contrast, a crypto bull market is one in which the major cryptocurrencies are on the rise.

One of the most famous crypto crash occurred in December 2017, when Bitcoin fell from almost $20,000 per coin to just over $3,200 in a matter of days. After that, it rallied, reaching a price of nearly $65,000 per coin in April of 2021, before dropping again to below $32,000 in May.

Traders aiming to time the markets aim to purchase cryptocurrencies or other assets at the bottom of a bear market, but it’s often difficult to know when a bear market has actually ended.

Why Is It Called a Bear Market?

The terms bull and bear markets come from stock trading, and according to some accounts their origins come from the style of attack each animal uses – a bull will charge with its horns pointed upward. A bear, on the other hand, towers over its opponents and swipes down.

Similarities Between Crypto and Stock Bull & Bear Markets

Investors don’t have experience with the performance of cryptocurrency during a stock bear market. The last true, sustained stock bear market occurred in 2007-2009. At the time, Bitcoin had just launched, gaining attention, if not yet acceptance. While calling a bull or a bear market in stocks or in cryptocurrency requires technical analysis of values, there are several other that both markets have in common:

Volatility

The value of both stocks and cryptocurrencies fluctuate over time, but some cryptocurrencies tend to gyrate severely due to liquidity constraints within the market and a less established derivatives market.

Recommended: Why Is Bitcoin So Volatile?

Trader Sentiment

In both the stock market and cryptocurrency negative trader sentiment can portend a bear market. However, contrarian traders in both cases may see market dips as an opportunity to buy cryptocurrency at a discount. Outside Influences Bear markets, in both stocks and cryptocurrency, can reflect external factors that change the way that investors value a particular asset. Those factors can include overall economic strength, interest rates, or geopolitical factors.

What Are the Signs of a Crypto Bear Market?

One of the most famous maxims in all of investing is “buy low, sell high.” In four words, it’s how investors make money. And it’s why, for crypto investors, knowing when a bear market is coming, or when one is just about to end, can make all the difference.

This is where the relative youth of the crypto market makes things difficult. With the stock market, economists, analysts and traders have decades and even centuries of data to sift through to find the trends and triggers that occurred just before a bear market turned to a bull and vice versa. Bitcoin, on the other hand, was launched in 2009.

Some warning signs of a crypto bear market include:

• Lower trading volume: This could indicate that people have begun holding their coins amid market uncertainty.

• “Backwardation”: This occurs when the price of an asset in the futures market is lower than its current market price.

• Death cross: This is a technical indicator in which an asset’s 50-day moving average crosses its 200-day moving average.

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What Are Indicators of a Crypto Bull Market?

Even though crypto’s history has essentially been a very lengthy bull market followed by a short, terrifying market free-fall, and another market bull run, some trends have popped up for investors to watch.

• Liquidity. Crypto took a hit at the beginning of the lockdowns in spring of 2020, when investors needed cash. But so did everything else. Then it rose, as the crisis receded and the Fed pumped trillions into the economy, aiding in Bitcoin’s liquidity and other cryptos alike.

• Adoption: If more companies and financial institutions adopt crypto, then it should move more in step with the economy, and be subject to less violent fluctuations. It’s a sign that the Wild West is being tamed. But adoption is a double-edged sword. If it’s your cab driver and barber who are talking about crypto, then it could mean that the market is oversaturated.

Should I Invest in Crypto?

There is also a baseline level of uncertainty with crypto that doesn’t exist in many other asset classes. While nobody thinks that regulators will shut down or curtail the stock market or that hackers will breach a stock exchange, these are common concerns with Bitcoin and other forms of cryptocurrency.

In addition to concerns about cryptocurrency regulation and blockchain security, there is also a growing debate about the energy costs of Bitcoin and other cryptocurrencies, which adds to the question mark over the long-term viability of crypto as a whole, at least in its current form. Those existential doubts rear up whenever Bitcoin, or other major cryptos, take a steep decline, or fall for too long.

That existential doubt can also be a major plus for investors, however. The shadows over crypto means that their declines are often incredibly steep. That creates regularly occurring opportunities to buy the crypto of your choice at a very steep discount, if you believe in the long-term growth of crypto as a whole, and if you can wait for the dip. Proponents of cryptocurrencies, including Bitcoin, believe that its growing adoption and use make it a smart long-term investment.

The Takeaway

Like all assets, cryptocurrencies go through cycles in which their value rises and falls. For short-term investors, especially, knowing the signs of a bear market can help you create a portfolio strategy that makes sense for your risk appetite and financial goals.

Photo credit: iStock/Eva-Katalin

First Trade Amount		Bonus Payout
Low	High	Bonus Payout
$50	$99.99	$10
$100	$499.99	$15
$500	$4,999.99	$50
$5,000+		$100

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Aug

2021

What is an Impermanent Loss?

By Brian O'Connell | Growing Wealth, invest, Investing | Comments Off

Impermanent loss can be a financial fact of life for cryptocurrency token holders – who may not even be aware it exists.

Impermanent loss involves a liquidity risk centered on the pricing algorithms used by so-called decentralized finance (DeFi) exchanges, which can impact portfolio asset values.

To define impermanent loss, cryptocurrency investors must first understand the difference between holding tokens in an automated market maker (AMM) and holding coins on your own, usually in a crypto wallet. (An AMM is a digitalized and decentralized cryptocurrency exchange protocol that uses its own statistical formula to set cryptocurrency prices.)

Liquidity providers act as a broker of sorts, by depositing an equal number of assets into the exchange, with two funded assets per liquidity pool. Liquidity providers stake their digital assets to earn trading fees made in the pool, with the size of the liquidity pool contribution. Impermanent loss is the opportunity cost that comes from staking crypto with an AMM.

Recommended: What Is DeFi (Decentralized Finance)?

As in-the-know crypto traders might say, impermanent loss could leave an investor rekt, meaning with a substantial loss.

What Is Impermanent Loss?

An impermanent loss is the money that a liquidity provider loses when the value of crypto deposited into an automated market maker, a type of DeFi exchange, differs from the value of that crypto if it were stored in a crypto wallet.

Pricing volatility can present an investment risk when liquidity-minded investors hold tokens in an AMM, and when those prices do diverge significantly, impermanent losses can mount up, impacting the value of an overall crypto portfolio.

However, the losses can be offset–completely or partially–by fees that the decentralized exchange pays for liquidity providers. Exchanges that have high volume tend to pay higher fees to liquidity providers, which can minimize the impermanent losses that leave investors at a net negative.

How Does Impermanent Loss Happen?

The key factor with impermanent loss is the way automated market makers work. As noted above, AMM’s enable investors to trade digital financial assets like cryptocurrencies without the permission of the token holder. AMMs allow for this type of trading by leveraging liquidity pools in lieu of the more stable and traditional form of asset trading, which relies on the “buyer-and-seller” stock exchange model.

AMMs allow any investor to fund a liquidity pool and act as a de facto market maker in pairing trades and charging trading fees. Impermanent risk is the downside risk in that scenario.

With volatile assets like cryptocurrency, over time the value of those assets may not equal the value they held when first deposited (i.e., their dollar value can shift downward or upward from the time of deposit to the time of withdrawal.) The more substantial the price change, the higher the chances the liquidity provider is exposed to impermanent loss.

How much can a liquidity pool funder lose? The science isn’t exact, but data indicates that an asset price change of just 1.25% can lead to a 0.6% deprecation in funded pool assets, relative to holding the assets in a digital wallet instead of using the assets to pair trades. A significantly higher price change of five times the initial price deposit could lead to a 25% decrease in asset value.

When pairing trades, liquidity pools may have one asset that’s relatively stable and one asset that is susceptible to higher pricing volatility. In that case, the odds of a significant loss impairment are higher than when the paired tokens are both stable and have a low exposure to impairment loss.

An Impermanent Loss Example

In an AMM scenario, the protocol’s decentralized structure digitalizes the cryptocurrency trading model, essentially setting a price between two different cryptocurrency assets. AMM uses an algorithm to set these prices on a constant basis, which can trigger volatility between the two assets.

Often, those assets can differ in structure. For instance, one cryptocurrency may be a stablecoin and the other can be a more volatile crypto asset, like Ethereum. In this scenario, the more volatile asset is Ethereum, which can change value quickly on trading markets, even as de-fi exchanges set prices on the cryptocurrency.

Ideally, exchanges want to offer equal liquidity levels when setting a price between two assets. Yet when one of the assets quickly rises or declines significantly in value, it changes the pricing structure. Now, the automated market’s trading price on stablecoin and Ethereum (using the above examples) is out of skew with the real value of the more volatile asset (Ethereum, in this case.) The markets will try to fix this pricing discrepancy, as traders wade in to the AMM to buy and invest in Ethereum at a discounted price. When enough traders do this, they drive the price up, and the AMM pricing structure once again is in balance.

Recommended: What Is a Stablecoin?

That scenario can have a major impact on the liquidity holder’s portfolio value. The liquidity provider, usually a cryptocurrency investor who leverages automated markets to find profit opportunities, may lose value based on the way AMM operates. When the provider trades on an AMM platform, they’re normally required to fund the two assets (as in the stablecoin and Ethereum example above) so traders can transition between the two assets by trading those assets in pairs.

When one of the paired asset prices is volatile, the investor can wind up with more of one of the cryptocurrency assets than expected, and less of the other. That hit to the current value of their portfolio assets compared to what the assets would be worth if left untraded, and kept stored in a digital wallet (that difference represents the impermanent loss).

It’s worth noting the loss in value may be temporary, if the value of the asset returns to the value at deposit, before the liquidity provider removes their crypto. Until then it’s an unrealized loss that only becomes permanent when the investor pulls their coins from the liquidity pool for good.

The Takeaway

Cryptocurrency investors are increasingly using liquidity pools to cull profits from automated market makers. In the process, liquidity-minded investors may be leaving themselves exposed to imperfect DeFi asset pricing, leading to impermanent loss that can reduce the value of their cryptocurrency portfolios.

Blockchain in Insurance: Evaluating the Pros & Cons

Blockchain 101: The Basics

How Does Blockchain Help Insurance?

Enhanced efficiency

Trust and transparency

Claims processing

Smart contracts

Insurance fraud

Drawbacks to Blockchain in Insurance

Potential Blockchain Use Cases in Insurance

Health Insurance

Property Insurance

Travel Insurance

Title Insurance

What Companies Use Insurance in Blockchain?

Blue Cross

Lemonade

FidentiaX

IBM

Allianz

Universal Fire & Casualty Insurance

MetroMile

The Takeaway

SegWit: Definition & How it Works

What Is SegWit?

How Does SegWit Work?

What Problems Does SegWit Solve?

The Transactions Problem

The Malleability Problem

The Scalability Problem

When Was SegWit Created?

A hard fork

A soft fork

What Was Segwit2x?

Should You Use SegWit?

The Takeaway

Guide to Eco-Friendly Cryptocurrencies

Why Does Bitcoin Require So Much Energy?

12 Most Sustainable Cryptocurrencies

1. Ethereum (ETH)

2. Nano

3. Chia (XCH)

4. Stellar Lumens (XLM)

5. Polkadot (DOT)

6. Hedera Hashgraph (HBAR)

7. Holo (HOT)

8. Ripple (XRP)

9. IOTA

10. Solarcoin (SLR)

11. Bitgreen (BITG)

12. EOSIO (EOS)

The Takeaway

What is a Crypto Bear Market?

What Is a Crypto Bear Market?

Why Is It Called a Bear Market?

Similarities Between Crypto and Stock Bull & Bear Markets

Volatility

Trader Sentiment

What Are the Signs of a Crypto Bear Market?

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What Are Indicators of a Crypto Bull Market?

Should I Invest in Crypto?

The Takeaway

What is an Impermanent Loss?

What Is Impermanent Loss?

How Does Impermanent Loss Happen?

An Impermanent Loss Example

The Takeaway

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