LiquidityMining

Key Takeaways

Impermanent loss happens when the price ratio of your tokens changes compared to when you deposited them in a liquidity pool.

The larger this change, the greater the potential loss relative to simply holding the tokens (HODLing).

This means you could end up losing money by providing liquidity to DeFi pools. It comes from an inherent design characteristic of a special kind of market called an automated market maker (AMM).

Providing liquidity to a liquidity pool can be profitable, but you’ll need to keep the concept of impermanent loss in mind to avoid potential losses.

Introduction

Decentralized finance (DeFi) protocols have seen an explosion of volume and liquidity. They enable essentially anyone with funds to become a market maker and earn trading fees. Democratizing market making has enabled a lot of frictionless economic activity in the crypto space.

So, what should you know before providing liquidity on these platforms? One of the most important concepts to understand is impermanent loss—and that’s what we’ll cover in this article.

What Is Impermanent Loss?

Impermanent loss happens when you provide liquidity to a pool, and the price ratio between the assets you deposited changes compared to when you deposited them. 

The bigger this change, the more exposed you are to impermanent loss. This means that, at withdrawal, the dollar value of the assets you get back may be less than if you had simply held them outside the pool.

Pools containing assets with relatively stable price ratios—such as stablecoins pegged to the same currency or different wrapped versions of a coin—tend to have a lower risk of impermanent loss. However, even stablecoins can experience depegging events, which can increase risk temporarily.

Why do liquidity providers (LPs) still participate despite this risk? Because impermanent loss can often be offset or even fully compensated by the trading fees earned while providing liquidity.

For example, Uniswap charges a fee on every trade, which goes directly to liquidity providers. If there is sufficient trading volume, the fees collected can make providing liquidity profitable, even in pools exposed to impermanent loss. Profitability depends on the protocol, the specific pool, the assets, and broader market conditions.

How Does Impermanent Loss Happen?

Let’s go through an example of how impermanent loss may look like for a liquidity provider.

Alice deposits 1 ETH and 100 USDC into a liquidity pool. In this particular automated market maker (AMM), deposited tokens must have an equivalent dollar value at deposit. So, in this example, the price of 1 ETH is 100 USDC, making Alice’s deposit worth $200.

In addition, there’s a total of 10 ETH and 1,000 USDC in the pool – funded by other LPs just like Alice. So, Alice has a 10% share of the pool, and the total liquidity is 10,000.

Let’s say that the price of ETH increases to 400 USDC. While this is happening, arbitrage traders will add USDC to the pool and remove ETH from it until the ratio reflects the current price. Remember, AMMs don’t have order books; prices are determined by the ratio of tokens in the pool.

Because the AMM maintains a constant product of reserves (x * y = k), the quantities in the pool adjust to reflect the price change. Now, there are approximately 5 ETH and 2,000 USDC in the pool, thanks to the work of arbitrage traders.

When Alice withdraws her 10% share, she receives 0.5 ETH and 200 USDC, which together are worth $400. Nice! This is a 100% increase from her initial $200 deposit. However, if Alice had simply held her initial 1 ETH and 100 USDC, her holdings would be worth $500 now.

We can see that Alice would have been better off by HODLing rather than depositing into the liquidity pool. This is what we call impermanent loss. The loss is “impermanent” because if the price ratio returns to its previous state, the loss would disappear.

Note that this example does not account for trading fees. The fees Alice earned while providing liquidity could offset or exceed this loss, making liquidity provision profitable. But keep in mind that impermanent loss can lead to big losses (including a significant portion of the initial deposit).

Impermanent Loss Estimation

So, impermanent loss happens when the price of the assets in the pool changes. But how much is it exactly? We can plot this on a graph. Note that it doesn’t account for fees earned for providing liquidity.

Here’s a summary of what the graph is telling us about losses compared to HODLing:

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

Note that impermanent loss occurs regardless of whether the price moves up or down. The only thing impermanent loss cares about is the price ratio relative to the time of deposit.

The Risks of Providing Liquidity to an AMM

The term “impermanent loss” can be misleading. The “impermanent” part means the loss is unrealized as long as you keep your tokens in the pool. If you are lucky, the price ratio might revert. However, once you withdraw your assets, any losses become permanent.

The trading fees you earn during liquidity provision may offset or surpass these losses, but it’s important to be aware of the risks upfront. Be cautious about depositing larger amounts initially. Start small to gauge the returns and risks involved.

Also, consider the volatility of the assets in a pool—more volatile pairs tend to have higher impermanent loss risk.

Finally, look for well-established AMMs. Because DeFi protocols are easy to fork or modify, new or unaudited AMMs may have bugs or risks that can trap your funds. Be wary of pools promising unusually high returns, as those may come with higher risks.

Reducing risks

Modern AMM designs offer features such as concentrated liquidity or stablecoin-optimized pools, which can reduce impermanent loss risk. There are also single-sided liquidity provision options emerging. Exploring these alternatives may help users mitigate some of the common risks.

Closing Thoughts

Impermanent loss is one of the fundamental concepts that anyone who wants to provide liquidity to AMMs should understand. In short, if the price ratio of the deposited assets changes since the deposit, the liquidity provider may be exposed to impermanent loss.

Further Reading

Why Do Stablecoins Depeg?

What Is an Automated Market Maker (AMM)?

What Is Uniswap and How Does It Work?

What Is Decentralized Finance (DeFi)?

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