The DeFi scene has exploded in recent years, with a number of successful protocols contributing to the rising volume and liquidity (Uniswap, PancakeSwap, and SushiSwap to name a few). While these protocols have entirely democratised trading in the crypto space, there are still some risks associated with getting involved.
If you have experience in DeFi trading you’ve likely come across this term. Impermanent loss refers to losses made as a result of the price changes of the digital assets from when the liquidity provider deposited them into the liquidity pool to when you withdrew them. Below we break down how impermanent loss happens and how to manage the risk.
How does impermanent loss happen?
Impermanent loss is when the price of the digital asset changes from the time you deposited it, providing liquidity to a liquidity pool, to the time you withdrew it. The bigger this change, the bigger the loss (essentially less dollar value at the time of withdrawal). There are of course ways to mitigate impermanent loss.
Liquidity providers' exposure to impermanent loss is decreased when trading in pools with assets that have smaller price ranges, like stablecoins (a stable asset) and wrapped versions of coins for example. In these cases, liquidity providers can provide liquidity with a lower risk of impermanent loss.
In some cases, impermanent loss can also be counteracted by trading fees. Liquidity pools exposed to a high risk of impermanent loss can still be profitable thanks to lucrative trading fees.
For example, Uniswap offers liquidity providers 0.3% on every trade, so if the pool has a high trading volume, liquidity providers can still make money even if exposed to impermanent loss. This will depend on the protocol, deposited assets, specific pool, and wider market conditions. As mentioned prior, trading in the DeFi space is high risk.
What does impermanent loss looks like for liquidity providers in liquidity pools?
Here is an example of what impermanent loss might look like for a liquidity provider trading on automated market makers (AMM).
Say John finds an automated market maker that requires a pair of digital assets equating to the same value. For the sake of this example, say 1 ETH is equivalent to 1,000 USDT, which he deposits in a liquidity pool. The total value of his deposit, therefore, sits at $2,000.
Other liquidity providers have contributed a combined offering of 10 ETH and 10,000 USDT into the liquidity pool, meaning that John holds a 10% share of the overall liquidity pool.
Let's say that the price of ETH rises to 4,000 USDT. During this time, arbitrage traders will contribute USDT to the liquidity pool and remove ETH until the ratio reflects the price increase. Note that AMMs don't have order books. Instead, the price of assets is determined by the ratio between them in the liquidity pool, meaning that while the liquidity remains constant, the ratio of assets in it changes.
In this case, if the price of ETH is now worth 4,000 USDT then the arbitrage traders will work to ensure that the liquidity pool now holds 5 ETH and 20,000 USDT. The liquidity pool's total liquidity is now worth $40,000.
If John decides to withdraw his funds, he's entitled to 10% of the liquidity pool's share based on his initial deposit and the size of the liquidity pool. He, therefore, is entitled to withdraw 0.5 ETH and 2,000 USDT, equating to $4,000 in value. However, if he'd kept the initial 1 ETH and 1,000 USDT this would be worth $5,000 now.
In this case, John would have made bigger returns had he hodled instead of using the liquidity pool and this is what impermanent loss is all about.
This example does not incorporate trading fees that John might have earned for providing liquidity to the liquidity pool. In many cases, these fees would cancel out the losses and potentially make the process profitable. Either way, understanding what impermanent loss is, is imperative before providing liquidity in the DeFi space.
A look at impermanent loss vs price increases (excl trading fees)
So, impermanent loss happens when the price of the cryptocurrency assets in the liquidity pool changes. Here is an overview of the impermanent losses incurred due to asset price increases (note that trading fees are not factored in here). Impermanent loss examples:
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 happens whether the price both increases or decreases as it is calculated by the price ratio relative to the time of the initial deposit into the liquidity pool. Unfortunately in these cases, price volatility leads liquidity providers to lose money.
The risks associated with becoming a liquidity provider
Realistically, impermanent loss isn't the best name. The losses are known as "impermanent" because they only become evident when you withdraw your coins from the liquidity pool. However, the "temporary loss" then becomes pretty permanent. Although the fees might be able to compensate for those losses, it does seem like a somewhat deceptive title.
When you put cryptocurrency assets into an AMM, be cautious. Some liquidity pools are far more vulnerable to fleeting losses than others, as we've discussed above. As a general rule, the more volatile the assets in the liquidity pool are, the greater your chance of being exposed to impermanent loss. It's also preferable to start by depositing a little bit of money in a liquidity pool to see the returns before exposing a lump sum.
Another thing to keep in mind is to look for more established, tried-and-true AMMs. It's fairly simple to fork an existing AMM and make a few modifications thanks to DeFi. However, this might introduce bugs that lock your funds in the liquidity pool indefinitely. If a liquidity pool promises exceptionally high returns, there's more than likely a tradeoff taking place and there's likely to be much higher risk associated. Be sure to understand the ins and outs of any liquidity pool before making any deposits.
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