WTF Is… Impermanent Loss

TLDR: Impermanent loss is a concept that's unique to the world of decentralized exchanges (DEXs), and it's important to understand if you're planning on using these platforms for decentralized finance (DeFi) trading. Impermanent losses happen when a liquidity provider temporarily loses value because the ratio of tokens inside a liquidity pool changed, whether due to new deposits, withdrawals or market fluctuations.

What is impermanent loss? 

To understand impermanent loss, we first need to understand other concepts that are correlated: how centralized exchanges (CEXs) and decentralized exchanges (DEXs) work, what is a liquidity pool or liquidity provider (LP) and what is an automated market maker (AMM).

Liquidity providers (LPs) on DEXs are people that hold crypto assets and contribute a pair of those assets to a pool, which is then used to facilitate trades between the assets. For providing this liquidity, LPs receive a portion of the trading fees generated by the DEX.

However, unlike centralized exchanges, where traders buy and sell assets from an order book managed by a third party (the exchange), DEXs use an automated market maker (AMM) to determine the price of assets and eliminate intermediaries. The AMM works with an algorithm that adjusts the price based on the relative supply and demand of the assets in the pool, rather than the price at which traders are willing to buy or sell. This means that when traders buy or sell an asset on a DEX, the price of that asset may change due to the change in the balance of assets in the pool.

When the price of an asset changes in this way, it can create impermanent loss for the LPs who provided liquidity to the pool. This occurs when the value of one asset in the pool increases or decreases relative to the other asset. 

An example of impermanent loss

If you feel like you’re having impermanent loss of brain cells, worry not.

Here’s an example to better:

Suppose you want to provide liquidity to a DEX pool for ETH and USDT. You provide 5,000 USDT and 5 ETH in a liquidity pool where the deposited token pair needs to be of equivalent value. (Let's assume the price of ETH is 1,000 USDT at the time of deposit to make the math work.) The total dollar value of your deposit is therefore $10,000 USD at the time of deposit.

Imagine there's now a total of 10 ETH and 10,000 USDT in the pool — funded by your $10,000 deposit and money from other LPs. So, you have a 50% share of the pool and the total liquidity is $20,000.

Things are peachy, right? But suddenly, the price of ETH drops to 500 USDT. When this happens, arbitrage traders will take advantage by adding ETH to the pool and removing USDT from it until the ratio reflects the current price. Because AMMs don’t have order books, what determines the price of the assets in the pool is the ratio between them. So liquidity remains constant in the pool ($20,000), but the ratio of the assets has now changed. There is now 15 ETH and 7,500 USDT in the pool.

If you decide to withdraw your funds at this point, you are still entitled to a 50% share of the pool. This means you can withdraw 7.5 ETH and 3,750 USDT, totaling 8,625 USD. You now have more ETH and less USDT. Had you hold the original assets and not added them to the liquidity pool, the value of your holdings would be 10,000 USD now. 

How to minimize the risk of impermanent loss

As you saw from the example, impermanent loss occurs when the price of one asset in the pool changes relative to the other asset. If the price remains the same, there is no impermanent loss. However, since the price of assets is constantly changing, impermanent loss is always a risk for LPs, but there are steps you can take to minimize it.

You are more likely to not get any impermanent loss when choosing stable pairs, because they are less volatile. The greater the price volatility of an asset, the greater the risk of impermanent loss. Therefore, choosing pairs with low volatility can help minimize the risk. However, you would be exposed to the weakest side of the two, which is a different risk to consider. “What could happen is that, if one of the stable coins de-pegs, you end up having a lot of the toxic asset. So, if you put 1,000 USDC and 1,000 USDT, but then USDC goes to zero, you're going to hold 2,000 USDC, you're not going to be holding any USDT,” said Julian Nesk, a data scientist at mStable, a decentralized and non-custodial protocol and stablecoin ecosystem.

Another way to minimize risk is to monitor the pool and adjust your holdings regularly. This will ensure that the relative balance of assets remains similar to the initial state when you added liquidity. If the balance changes significantly, you may want to adjust your holdings by adding or removing assets from the pool. 

You could also calculate potential impermanent loss before providing liquidity to a pool. “It's not that simple. There's a lot of complicated equations that you have to do to calculate it yourself. Anyone is free to jump into Uniswap’s white paper and try to do it, but there are easier options,” said Nesk. So, for anyone that is not a data scientist, mathematician or genius, there are online tools such as the one at DailyDeFi that allow you to calculate different possibilities of impermanent loss based on initial and future prices of your tokens. 

Some DEXs offer incentives to LPs to provide liquidity for certain pairs. For example, they may offer extra rewards for LPs who provide liquidity for a new token or during a specific time period. Others, like Curve and Balancer, allow LPs to earn extra fees in the form of token emissions from the protocol, which you can claim and sell. These sellings could counteract the loss. 

It's important to note that, even with these strategies, impermanent loss cannot be completely eliminated and, as anything in crypto, there are always risks. 

To sum it up

Impermanent loss is a unique risk that liquidity providers (LPs) face when providing liquidity to DEXs. It occurs when the price of one asset in the pool changes relative to the other asset, creating a temporary loss of value for the LP. However, by choosing low volatility pairs, monitoring the pool and adjusting holdings, calculating potential loss in advance and taking advantage of incentives, LPs can minimize the impact of impermanent loss on their trades. 

As always, be aware of the risks and only contribute funds that you can afford to lose.

This is not financial advice. If you don't want to spend money investing in crypto or Web3 — you don’t have to. The intent of this article is to help others educate themselves and learn.

Sabrina Bonini is the Founder of Cripto Es Cultura, a community and creative agency that helps brands and creators adapt to the Web3 and NFT space. She pays special attention to the education and empowerment of Spanish-speaking artists, women and underrepresented groups and is fully committed to helping make the blockchain ecosystem more diverse and inclusive. Connect with her on Twitter @criptoescultura.

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