Impermanent Loss Explanation
Providing liquidity on platforms such as Uniswap, SushiSwap or PancakeSwap has become increasingly popular recently. These liquidity protocols allow anyone who has funds to take part in market making and earn trading fees. This democratization of market making has allowed for easy economic activity in the cryptocurrency world.
If you wish to provide liquidity for these platforms, what do you need to understand? In this article, we will focus on one essential concept – impermanent loss.
What is impermanent loss?
Providing liquidity to a liquidity pool can result in impermanent loss if the price of the assets you deposited changes from when you originally put them in. The more drastic this change, the greater your exposure to such a loss.
Loss is defined as having less dollar value when withdrawing than when depositing. To minimize risk of impermanent loss, pools that contain assets with relatively stable prices are ideal; examples are stablecoins and different forms of a particular coin. LPs will then have smaller chances of experiencing impermanent loss.
Despite the risk of potential losses, liquidity providers continue to offer liquidity because they can offset impermanent loss through trading fees. In fact, even Uniswap pools that are prone to impermanent loss can be profitable due to the associated trading fees.
Uniswap charges a 0.3% fee on all swaps, with the proceeds going to liquidity providers. If there is high trading activity in a particular pool, it can be lucrative to offer liquidity even when the pool is subject to substantial impermanent loss. This will depend on the protocol, the pool in question, the assets held and general market conditions.
How does impermanent loss happen?
Let’s use an example to illustrate the concept of impermanent loss for a liquidity provider.
Alice places 1 ETH and 100 DAI into a liquidity pool, where the two tokens must be of equal value. This means that when she deposits them, 1 ETH is worth 100 DAI and their combined value is 200 USD.
Additionally, there are 10 ETH and 1,000 DAI already in the pool from other liquidity providers. Alice owns a portion of the pool that amounts to 10% of the total amount, which is 10,000.
If the value of ETH goes up to 400 DAI, arbitrage traders will move DAI into the pool and ETH out of it until the ratio in the pool reflects that price. It is important to note that Automated Market Makers do not use order books; what sets prices for assets in the pool is their relative ratio. Even though there may be a fixed amount of liquidity (10,000) within it, this ratio can fluctuate.
The ratio of ETH to DAI in the pool has altered as a result of ETH now being priced at 400 DAI. Arbitrage traders have been successful in bringing 5 ETH and 2,000 DAI into the pool.
Alice opts to take out her money. We already know that she is entitled to 10% of the pool, so she can withdraw 0.5 ETH and 200 DAI which amounts to 400 USD. She has made a profit since her original deposit of tokens was worth 200 USD, but what if she just kept hold of 1 ETH and 100 DAI? The combined value of these holdings would now be 500 USD.
Alice would have been better off if she had held onto her assets rather than putting them into a liquidity pool, an example of impermanent loss. Although the initial deposit wasn’t large in this case, it is important to note that this kind of loss can potentially result in a substantial portion of the original investment being lost.
Alice’s illustration disregards the trading fees she could have gained by supplying liquidity. Usually, the fees earned would cancel out any losses and make supplying liquidity lucrative regardless. Nevertheless, it is essential to comprehend impermanent loss before offering liquidity to a DeFi protocol.
Impermanent loss estimation
Therefore, when the assets in the pool fluctuate in price, a temporary reduction is experienced. However, what is the exact amount? This can be depicted on a graph. It should be noted that this does not include any fees earned from 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
It’s essential to be aware that regardless of the direction of the cost fluctuation, impermanent loss will occur. Impermanent loss is only concerned with how much the price has shifted compared to when it was initially deposited.
The risks of providing liquidity to an AMM
The term “impermanent loss” is a bit of a misnomer, since these losses become permanent when coins are taken out of the liquidity pool. Although the fees earned may make up for them, it’s important to be cautious when depositing funds into an Automated Market Maker (AMM). It’s usually riskier to use pools with more volatile assets, as they are more prone to suffering from impermanent loss.
Beginning with a small deposit is often beneficial as it can give you an idea of what returns to expect prior to investing a larger sum.
It is also important to stick with well-established AMMs. Since DeFi enables people to take an existing AMM and make slight modifications, you may be exposed to bugs that can leave your funds stuck in the system. If a liquidity pool offers unusually high returns, there is probably a downside and higher risks involved.