Impermanent Loss
What Is Impermanent Loss
Impermanent loss is a concept that occurs when you provide liquidity to an automated market maker (AMM) and the prices of the tokens in the pool diverge in value compared to when you first deposited them. It's called "impermanent" because the loss only becomes permanent if you withdraw your liquidity while the prices have diverged; if the prices return to the same ratio as when you deposited, the loss disappears.
Automated Market Makers (AMMs)
In traditional finance, markets have "order books" where buyers and sellers place bids and asks. In contrast, AMMs replace the need for a traditional order book. Instead of matching buyers and sellers directly, AMMs rely on liquidity pools, where users provide liquidity by depositing pairs of tokens.
For example, in the Uniswap AMM model, a liquidity provider might deposit an equal value of two tokens (e.g., ETH and DAI) into a pool. The pool allows other users to swap between these tokens, using a mathematical formula to determine the price. One common formula is the constant product formula, where the product of the two token quantities remains constant:
x * y = k
Where:
x = amount of one token in the pool (e.g., ETH)
y = amount of the other token in the pool (e.g., DAI)
k = constant product
This ensures that as users swap tokens, the prices adjust based on the pool's liquidity.
How Impermanent Loss Happens
Impermanent loss occurs when the price of one or both tokens in the liquidity pool changes after you deposit them. Here’s an example to explain this:
Step 1: You provide 1 ETH and 1,000 DAI to a liquidity pool (assuming 1 ETH = 1,000 DAI at the time).
Step 2: If ETH increases in price to 1,500 DAI (ETH appreciates relative to DAI), arbitrage traders will buy ETH from the pool (since it’s cheaper than in other markets) and add DAI, rebalancing the pool.
Step 3: As a liquidity provider, you now have less ETH and more DAI in your share of the pool. If you withdraw at this moment, you’ll receive less than 1 ETH and more than 1,000 DAI.
Even though the total value of your tokens in the pool may have increased due to the price rise, the value of what you would have had by simply holding (HODLing) your 1 ETH and 1,000 DAI without providing liquidity is higher than your liquidity pool value. This difference is the impermanent loss.
Key Factors Influencing Impermanent Loss
Price Divergence: The larger the price change between the tokens, the larger the impermanent loss.
Liquidity Provider Fees: AMMs charge trading fees, which go to liquidity providers. These fees can offset impermanent loss if trading volume is high.
Volatility: More volatile pairs tend to experience greater price divergence, leading to more impermanent loss.
Time in the Pool: Impermanent loss becomes permanent only if you withdraw liquidity. If prices revert back to their original ratios, the loss disappears.
Why Impermanent Loss is "Impermanent"
If the price ratio of the tokens in the pool returns to the same level as when you deposited, your impermanent loss disappears.
Even if the price diverges, fees earned from trading activity in the pool may more than compensate for the impermanent loss.
How to Minimise Impermanent Loss?
Impermanent loss can be minimised by understanding how it functions and taking precautions to reduce your risk. Here are several methods you can use to mitigate impermanent loss:
Managing the Size of Your Position
Limiting the size of your position in the liquidity pool is one strategy to prevent temporary loss. You may lessen the effect of price changes on your portfolio by keeping your position small.
Selecting Stablecoin Pairs Carefully
To reduce the chances of suffering impermanent loss, select stablecoin pairings such as USDT/USDC or DAI/USDC. These cryptocurrency pairs are less volatile than others and are more unlikely to see substantial price movements.
Employing a Hedging Approach
A hedging strategy can be used to reduce temporary loss. One method is to sell the assets in the pool short. If the price of the asset declines, you will profit on your short position, which will make up for the loss in the liquidity pool.
Should I Still Provide Liquidity to a Particular Pool?
It's vital to acknowledge that supplying liquidity to a decentralized market carries the risk of impermanent loss. While it can be reduced to some degree, it cannot be eliminated entirely. As a result, it's critical to assess the possible advantages against the dangers before deciding whether to provide liquidity to a certain pool.
Even if you're already doing so, keep an eye out for news and developments on the tokens in the liquidity pool for which you're providing liquidity, as well as any shifts in broader market conditions. This enables you to make an educated judgment on when to deposit and withdraw tokens from the pool.
Ultimately, impermanent loss is an indispensable concept for crypto traders to be aware of, especially those who are providing liquidity to decentralized exchanges. Traders can reduce their risk of impermanent loss through the use of various strategies such as adhering to low-volatility trading pairings, using impermanent loss calculators, diversifying liquidity sources, and paying attention to market conditions. However, it is critical to remain informed and updated in order to balance the potential benefits and possible risks.