Impermanent Loss
What is impermanent loss?
Impermanent loss happens when you provide liquidity to a liquidity pool
Impermanent loss happens when you provide liquidity to a liquidity pool, and the price of your deposited assets changes compared to when you deposited them. The bigger this change is, the more you are exposed to impermanent loss. In this case, the loss means less dollar value at the time of withdrawal than at the time of deposit.
Pools that contain assets that remain in a relatively small price range will be less exposed to impermanent loss. Stablecoins, for example, will stay in a relatively contained price range. In this case, there’s a smaller risk of impermanent loss for liquidity providers (LPs).
So why do liquidity providers still provide liquidity if they’re exposed to potential losses? Well, impermanent loss can still be counteracted by trading fees. In fact, even pools on TokenSwap that are quite exposed to impermanent loss can be profitable thanks to the trading fees.
TokenSwap charges 0.25% on every trade that directly goes to liquidity providers. If there’s a lot of trading volume happening in a given pool, it can be profitable to provide liquidity even if the pool is heavily exposed to impermanent loss. This, however, depends on the protocol, the specific pool, the deposited assets, and even wider 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 BSV and 100 USD in a liquidity pool. In this particular automated market maker (AMM), the deposited token pair needs to be of equivalent value. This means that the price of BSV is 100 USD at the time of deposit. This also means that the dollar value of Alice’s deposit is 200 USD at the time of deposit.
In addition, there’s a total of 10 BSV and 1,000 USD 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(value K in formula x * y = k).
Let’s say that the price of BSV increases to 400 USD. While this is happening, arbitrage traders will add USD to the pool and remove BSV from it until the ratio reflects the current price. Remember, AMMs don’t have order books. What determines the price of the assets in the pool is the ratio between them in the pool. While liquidity remains constant in the pool (10,000), the ratio of the assets in it changes.
If BSV is now 400 USD, the ratio between how much BSV and how much USD is in the pool has changed. There is now 5 BSV and 2,000 USD in the pool, thanks to the work of arbitrage traders.
So, Alice decides to withdraw her funds. As we know from earlier, she’s entitled to a 10% share of the pool. As a result, she can withdraw 0.5 BSV and 200 USD, totaling 400 USD. She made some nice profits since her deposit of tokens worth 200 USD, right? But wait, what would have happened if she simply holds her 1 BSV and 100 USD? The combined dollar value of these holdings would be 500 USD now.
We can see that Alice would have been better off by holding rather than depositing into the liquidity pool. This is what we call impermanent loss. In this case, Alice’s loss wasn’t that substantial as the initial deposit was a relatively small amount. Keep in mind, however, that impermanent loss can lead to big losses (including a significant portion of the initial deposit).
With that said, Alice’s example completely disregards the trading fees she would have earned for providing liquidity. In many cases, the fees earned would negate the losses and make providing liquidity profitable nevertheless. Even so, it’s crucial to understand impermanent loss before providing liquidity to a DeFi protocol.
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
There’s something important you also need to understand. Impermanent loss happens no matter which direction the price changes. The only thing impermanent loss cares about is the price ratio relative to the time of deposit. If you’d like to get an advanced explanation for this, check out pintail’s article.
The risks of providing liquidity to an AMM
Be extra careful when you deposit your funds into an AMM. As we’ve discussed, some liquidity pools are much more exposed to impermanent loss than others. As a simple rule, the more volatile the assets are in the pool, the more likely it is that you can be exposed to impermanent loss. It can also be better to start by depositing a small amount. That way, you can get a rough estimation of what returns you can expect before committing a more significant amount.
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