Decentralized Finance (DeFi) offers thousands of yield farming opportunities, enabling you to make passive income on your coins and tokens. One of the most common options is depositing your crypto to an AMM liquidity pool, where you’ll earn rewards for providing trading liquidity. However, AMMs come with some unique risks, chief among which is “impermanent loss”.
Impermanent loss is a crucial consideration for liquidity providers, but it can be hard to understand. In this article, we will demystify this concept, explaining how it works and how to manage your risk.
Impermanent loss happens when assets you’ve deposited in a liquidity pool are worth less than they would have been if you had simply held them in your wallet.
The “loss” in impermanent loss refers to the reduction in the value of some of your deposited tokens (relative to their market value) due to the algorithm that controls the liquidity pool. The “impermanent” part is because, in theory, it only becomes permanent if you withdraw your tokens from the pool during periods of price volatility. The loss can be minimized or even reversed if the market prices return to their original levels.
To understand what causes impermanent loss, you need to grasp how AMMs and liquidity pools function. Liquidity pools are a key feature of decentralized exchanges (DEXs) that use automated market makers (AMMs) to facilitate trades. By depositing two tokens into a pool, liquidity providers create the market and earn a share of the trading fees.
Unlike traditional exchanges that rely on order books, AMMs adjust token prices within the pool algorithmically, based on supply and demand. This means the value of your deposited coins will change depending on trading activity within the protocol.
Let’s say you deposit ETH and USDC into a liquidity pool. The AMM ensures that for every trade, the ratio between ETH and USDC changes maintain balance within the protocol – this means the price of assets in the pool won’t necessarily track with the real market value.
For example, if the value of ETH increased after you deposited your funds, the price of ETH within the liquidity pool would be less than its market value. Arbitrage traders would see this opportunity, and buy ETH from the protocol to sell elsewhere for a profit. Since this would cause the amount of ETH in the pool to decrease, the protocol would automatically rebalance the pricing of that pair, selling ETH for more USDC to ensure it never runs out.
By contrast, if you had simply held your ETH and USDC, you would benefit fully from the appreciation of ETH, without sustaining the loss in value of your USDC in the liquidity pool’s rebalancing process.
If you withdrew your crypto during this period, you would realise an impermanent loss. This loss is the difference between the value of your withdrawal, and what you would have made by simply keeping the crypto in your wallet instead of providing liquidity.
Impermanent loss can be calculated using the formula that compares the value of your tokens if you had held them versus their value in the liquidity pool. While the formula can get complicated, there are several tools, such as the impermanent loss calculator, that can help you estimate the impact of price changes on your assets in a pool.
In general, the formula for impermanent loss is:
Where P represents the price change ratio between the two tokens.
For example, if the price of one token doubles (P = 2), you would experience an impermanent loss of around 5.7%. This doesn’t account for the fees earned, which could help offset the loss.
It’s important to rememeber that impermanent loss is only realised if you withdraw your deposited crypto during periods of imbalance. Therefore, it’s normally an avoidable risk if you’re well informed on how to handle price volatility. Here are some steps you can take to negate the effects of impermanent loss:
Impermanent loss is a crucial concept for anyone planning to provide liquidity in decentralized exchanges. While it can be a risk, understanding how it works and managing your crypto properly can help mitigate potential losses.