What is impermanent loss? People who are greatly involved with decentralized finance (DeFi) would have almost certainly heard this term before. Impermanent losses happen when you become a liquidity provider for liquidity pools. The loss is a result of the inherent characteristic of liquidity pools and the automated market maker (AMM).
What is impermanent loss?
Impermanent loss happens when you provide liquidity to a liquidity pool, and the price of your deposited assets changes compared to when you first deposited them. The greater this change is, the more you are exposed to impermanent loss. In this case, the loss is calculated from the decrease in the dollar value at the time of withdrawal compared to the time of deposit.
So, why even bother participating in liquidity pools? This is because impermanent loss can still be counteracted by trading fees. For example, pools on Uniswap that are quite exposed to impermanent loss can be profitable thanks to the trading fees. Uniswap charges 0.3% on every trade that happens in liquidity pools, and these fees go directly to liquidity providers. A particular pool with a large trading volume will therefore lead to a lot of trading fees going to liquidity providers, hence offsetting the impermanent loss incurred.
Well, how does this happen?
What is impermanent loss exactly? How does it happen?
Let’s assume you deposit 1 ETH and 100 DAI in a liquidity pool. In this particular automated market maker (AMM), the deposited token pair needs to be of equivalent value. This means that the price of ETH is 100 DAI at the time of deposit. This also means that the total dollar value of your deposit is 200 USD at the time of deposit.
Furthermore, it is known that there is a total of 10 ETH and 1,000 DAI in the pool. Thus, you have a 10% share of the pool. In this particular pool, the liquidity is 10,000.
Assume that the price of ETH increases to 400 DAI. While this is happening, arbitrage traders will add DAI to the pool and remove ETH from it until the ratio reflects the current price. AMMs essentially ensure that the ratio between the price of assets in the pool matches that of the liquidity. While liquidity remains constant in the pool (10,000), the ratio of the assets in it changes. Since ETH is now 400 DAI, there will now be 5 ETH and 2,000 DAI in the pool.
You then decide to withdraw your funds. As we know from earlier, you are entitled to a 10% share of the pool. As a result, you can withdraw 0.5 ETH and 200 DAI, totaling 400 USD. While you made some profits since your deposit of tokens worth 200 USD, you soon realise that you would have made more profits if you simply held on to your 1 ETH and 100 DAI. If you had done the latter, you would have tokens worth 500 USD.
Thus, you have made an impermanent loss of 100 USD. Of course, this does not take into account the amount of money made from trading fees. Typically, you hope that the money earned from trading fees exceed that of the impermanent loss, leading to an overall net profit.
How to calculate impermanent loss?
Impermanent loss happens no matter if the price increases or decreases.
A rough estimation of impermanent loss is as follows:
• 1.25x price change = 0.6% loss
• 1.50x price change = 2.0% loss
• 1.75x price change = 3.8% loss
• 2x price change = 5.7% loss
• 3x price change = 13.4% loss
• 4x price change = 20.0% loss
• 5x price change = 25.5% loss
In order to avoid impermanent loss, users should do their research before becoming liquidity providers. Impermanent loss can be reduced by choosing a pair of cryptocurrencies with less volatile prices, such as DAI and USDT.
Another way is to look for more tried and tested AMMs. DeFi makes it quite easy for anyone to fork an existing AMM and add some small changes. This may expose you to bugs, potentially leaving your funds stuck in the AMM forever. If a liquidity pool promises suspiciously high returns, be extra cautious because there is probably a tradeoff somewhere, and the associated risks are likely also higher.
In Conclusion
What is impermanent loss? We hope that this article has provided you with greater insight on the risk of being a liquidity provider. It is highly advisable that you are well-equipped with the knowledge before you become a liquidity provider.
