You may have heard about the term impermanent loss many times in DeFi. Here we cover everything about an impermanent loss, let’s dive in!
If you have been following the domain of DeFi closely, then you must have witnessed a prominent growth in popularity of DeFi protocols. New DeFi protocols such as SushiSwap, PancakeSwap, or Uniswap have showcased profound growth in terms of liquidity and volume of transactions. The liquidity protocols could basically help anyone with funds for becoming a market maker and earning passive income through trading fees.
However, the liquidity protocols have also been associated with a formidable risk, known as impermanent loss or IL. It basically refers to the loss when the price of tokens changes in comparison to their value upon depositing in the pool. Bigger fluctuations in the value often lead to bigger losses, thereby calling for attention towards understanding IL and its implications. The following discussion provides you with a detailed impermanent loss definition alongside showcasing examples of how it works and ways for calculating IL.
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What is an Impermanent Loss?
The first thing you would search in a discussion about IL would refer to its definition. Generally, the impermanent loss definition states that it is a loss you have to incur when the price of the assets you have deposited changes between the time of deposit and withdrawal. You can find the loss only when you have withdrawn your deposits from a liquidity pool.
The loss is generally a result of depositing two different cryptocurrencies in an automated market maker (AMM)-based liquidity protocol. When you withdraw your assets from an AMM liquidity pool at a later time with a profound difference in value, you will experience the loss. However, there are some situations where you would not lose money, albeit with trivial gains.
The characteristic name of impermanent loss refers to the fact that you can know about it only after withdrawing your funds from a liquidity pool. Prior to withdrawal, any type of loss estimated on the assets in a liquidity pool would only remain on paper. In the long run, the losses could disappear entirely or reduce by a considerable margin according to market movement.
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Liquidity Pools and Significance of AMMs
If you want to understand the answer to “What is an impermanent loss?” you should learn about liquidity pools. Liquidity pool generally includes two distinct tokens as a trading pair, such as the example of ETH and DAI. The liquidity pool includes ETH and DAI tokens with equal weightage for ensuring improved ease of trading for users.
For example, a pool of ETH and DAI would have a ratio of 50% ETH and 50% DAI. So, you can think of liquidity pools as a collection of crypto assets locked in a smart contract. Interestingly, liquidity pools serve a crucial role in enabling the facility of lending and trading services in DeFi markets.
Automated Market Makers or AMMs have emerged as a prolific highlight in discussions related to impermanent loss. AMMs have provided the foundation for developing many new decentralized crypto exchanges and liquidity pools. They employ the use of algorithms for managing the activity of a liquidity pool. Furthermore, the algorithm also takes care of pricing the tokens in the pool on the basis of trades in the pool.
In the case of common liquidity pools such as in Uniswap, you could find a constant formula-based algorithm for ensuring that values of the two cryptocurrencies in the pool are the same. At the same time, the algorithm also ensures the provision of liquidity, irrespective of the magnitude of the transaction. The AMM algorithm facilitates asymptotic increments in a token’s price with a growth in its desired quantity. Therefore, the price of a token in a liquidity pool would depend a lot on its proportion in the pool.
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Working of the Impermanent Loss
You would definitely need a practical impermanent loss example to obtain an understanding of how it works. IL generally influences the liquidity pools, which have to maintain an equal ratio of tokens by design. For example, users should provide equal portions of ETH and USDC into a USDC/ETH liquidity pool. Upon depositing cryptocurrency in the pool, users get the privilege of withdrawing equal portions of the other cryptocurrency in the pair. The ratio changes depending on the number of tokens in the pool, thereby influencing the price of the tokens.
Let us assume the example of a liquidity provider for understanding impermanent loss and its working in detail. If the liquidity provider adds 1 ETH and 100 USDC to the liquidity pool, then it ensures an equal value of both tokens in the pool. The dollar amount of the deposit will be $200 as their ETH and USDC would amount to $100 each.
Now, imagine that the liquidity pool has 1000 USDC and 10 ETH, setting the perfect 50:50 ratio. The liquidity provider in this impermanent loss example would receive around a 10% share in the transactions with the liquidity pool. Liquidity providers could receive LP tokens for redeeming the 10% of share in the pool at any time.
Everything looks quite seamless until now with a liquidity pool, and there is no sign of impermanent loss anywhere. The pricing of tokens in a liquidity pool depends considerably on the ratio between their liquidity pools. Therefore, you can find different prices of tokens in comparison to other exchanges. Now, suppose that the price of ETH experienced a 100% growth and is at $200 for each ETH.
Therefore, the liquidity pool would now include 1,414.21 USDC and 7.071 ETH for balancing the pool. It is important to note that the liquidity provider enjoys a 10% share in the liquidity pool. So, they could withdraw 141 USDC and 0.7071 ETH, amounting to $282. On the other hand, if they held the 1 ETH and 100 USDC without adding to the liquidity pool, then the value would have been $300. You can clearly notice the difference of $18, which is the impermanent loss incurred by the liquidity provider. If the change in the ratio of the pool had been larger, the loss would have been bigger.
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Calculating Impermanent Loss
The understanding of impermanent loss example clearly shows how the fluctuations in value of crypto tokens in liquidity pools can result in IL. However, it is also important to identify how to calculate IL and find out the possibilities of loss with specific liquidity pools. First of all, you should note that the tokens in the liquidity pool have a prominent role to play in an impermanent loss calculator. In addition, the number of liquidity providers in the pool also plays an important role in determining the IL.
You could find that ETH finds a stable asset for swapping in the ETH/USDC liquidity pool. On the other hand, you would have a higher risk of impermanent loss in liquidity pools with volatile tokens. Interestingly, you could find liquidity pools made purely of stablecoins such as USDC and DAI, which reduce the risk of IL. Stablecoins do not have any volatility and can help in maintaining stability of the pool effortlessly.
Just like decentralized exchanges, you could use an impermanent loss calculator for estimating the potential losses in advance. Some calculators offer you the facility of setting initial and future prices of two different tokens in a trading pair. You could easily get a detailed report of potential losses by comparing different scenarios. You could also find calculators which help you set the deposit amount and ratio of the pool manually.
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Risk of Offering Liquidity
There is nothing much positive you feel about the answers for “What is an impermanent loss?” in discussions on crypto. The term has become a prominent highlight in the newly emerging DeFi landscape. Many people perceive that IL could become a formidable setback for the growth of DeFi as it would discourage liquidity providers.
Furthermore, the fact that impermanent loss is inevitable is also another notable concern for liquidity pools and AMMs. However, you should also note that you don’t incur the loss if you do not withdraw the funds from the pool. On the other hand, the fees could help in compensating for the losses, which are actually permanent. So, it is quite crucial to evaluate the risks of IL before investing in AMMs.
Methods for Avoiding Impermanent Loss
While impermanent loss is an unavoidable phenomenon due to the volatility of crypto prices, you can avoid it. Here are some steps which can help you avoid the troubles due to impermanent losses.
- Go for trading pairs with stablecoins to avoid any concerns of impermanent losses. However, you could not benefit from an unprecedented rise in the market.
- Trading fees associated with liquidity pools offered to liquidity providers could also help in offsetting impermanent losses.
- While investments in stablecoin pairs might help in avoiding impermanent loss, they can reduce the possibilities of profit. On the other hand, you can choose trading pairs that have tokens with low volatility.
- Sometimes, the best way to avoid the storm is to wait it out. If you are estimating impermanent losses due to fluctuations in token prices, then you could wait until the prices resume to normal.
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As the world witnesses a radical growth in DeFi solutions and the adoption of crypto goes mainstream, impermanent loss has emerged as a notable concern. Primarily associated with liquidity pools, impermanent losses are the difference in price of crypto tokens at the time of deposit and withdrawal after fluctuation in prices. Irrespective of the rise or decline of price of any cryptocurrency in the trading pair, the liquidity provider has to experience impermanent losses.
Therefore, you could not undermine the possibility of impermanent losses in liquidity pools based on AMMs. On the other hand, you could also employ some promising measures for resolving the risks of impermanent losses. For example, you can invest in trading pairs with stablecoins or tokens with low volatility. Learn more about impermanent losses and counter them effectively now.
*Disclaimer: The article should not be taken as, and is not intended to provide any investment advice. Claims made in this article do not constitute investment advice and should not be taken as such. Do your own research!