Have you ever lost money deposited to a liquidity pool and wondered why it disappeared?
Well, the first thing you need to know is that you are not alone! Many other liquidity providers have certainly wondered the same thing.
You may not be aware, however, that something called impermanent loss could have had an effect on what happened.
In this article, you will learn what impermanent is and how it can affect your profit as a liquidity provider.
So, let's get to it.
So, what is Impermanent Loss?
Impermanent loss is a risk that’s always present when becoming a liquidity provider.
Basically, it occurs when there is a significant change in the price of tokens deposited by liquidity providers into liquidity pools. (For those that don’t know, liquidity pools are a collection of cryptocurrencies or tokens locked in a smart contract.)
As you may know, the premise of decentralized finance is that no central body controls it. So, to help enable transactions to happen, funds are pooled together from investors and liquidity providers in liquidity pools and protected by smart contracts.
In exchange, liquidity providers earn a share from trading fees on the decentralized exchange. It means they make a percentage of trading fees anytime someone transacts using that pool.
To understand this better, imagine it like investing in a company and purchasing shares with dividends available. If the company performs well, you earn more from your shares, but if the company does poorly, it’s reflected in the lower value of your returns.
From the outside, liquidity pools sound like a great way to make passive income. However, as with all forms of investment, it comes with risks. One of which is impermanent loss.
How does Impermanent Loss work?
First, an impermanent loss is called 'impermanent' because you don't necessarily have to lose anything. You only record a loss if you withdraw your funds from a liquidity pool when token values are experiencing a significant drop in value at the time.
If you waited until the price returned to the previous level before withdrawing, you would lose nothing.
So, let's look a little more closely at the mechanics behind impermanent loss.
Most exchanges require liquidity providers to provide liquidity in trading pairs on a ratio of 1:1. That means you can add, say, Ethereum and DAI at equivalent values.
Suppose the current price of 1 Ether is equal to 100 DAI - a stablecoin, and so you need to deposit 100 DAI for each Ether you add to the pool. In this example, you deposit 1 Ether and 100 DAI. In this example, as 1 DAI is equal to 1 US Dollar, your total investment is worth $200.
Now, let's say the entire pool has 10 Ether and 1000 DAI. In this case, your contribution represents 10% of the pool, so you'll earn 10% of the trading fees whenever someone makes a trade using this pool.
Perfect situation, right?
Well, unfortunately, there are no perfect situations in the finance world. Sometimes, currencies experience volatility. For example, if the price of Ether increases to 400 DAI, it creates opportunities for certain traders to buy Ether at a lower price and sell DAI to the pool, balancing out the ratio.
Who are those traders?
They're called arbitrage traders, and they're constantly on the lookout to make a profit from discrepancies in the market. As a result of these arbitrage traders, the pool’s ratio adjusts to match the new market rate but the liquidity in the pool remains constant.
As a result of these actions, then, there are now 5 Ether and 2,000 DAI in the pool. Keep in mind that Ether has grown in market value in this example though, and 1 Ether is now worth 400 DAI instead of the initial 100 DAI.
Also, remember that you own 10% of this liquidity pool. This means you can now withdraw 0.5 Ether and 200 DAI, which is worth $400. It may seem like a good deal since you initially deposited $200. However, if you had just held onto your 1 Ether and 100 DAI, the total value of your assets would now be $500.
By holding your assets instead of depositing them into the liquidity pool, you would have made an extra $100. This difference is referred to as impermanent loss.
Are there any ways to soften the blow?
It should be noted that your actual loss greatly depends on the network’s transaction fees, with fees contributing to any returns you make.
For instance, if the transaction fees in the scenario were extraordinarily high, from a lot of activity, it could actually cushion the loss from the price change - or even reverse the loss altogether.
This is why the loss is seen as impermanent. You only lose value if you withdraw at a time when asset prices are low. If you don’t withdraw, the gains made from the trading fees can sometimes surpass the loss from their price change.
Now, this is only one example. You should bear in mind that in some instances, it’s possible to lose much more if the price change is significant. In some cases, you could even lose part of your initial deposit.
The best way to work out what’s going on is to explain a few calculations - to help you make accurate decisions.
This is necessary because, on the surface, it is very difficult to know when you are at a loss. From the example I used earlier, at first glance it didn't seem like you lost anything. It’s only through carefully considering what you would have made that the bigger picture becomes clear.
How do you calculate impermanent loss?
Automatic market makers like Uniswap rely on the constant equation x * y = K to maintain the balance of tokens in a given liquidity pool. Here, x and y represent the quantities of two tokens, and K is the constant value that remains the same before and after any trades that occur in the pool. For example, if 10 Ether is paired with 1000 DAI, then the resulting K value is 10,000.
If the price of one token changes, the equation automatically adjusts to keep K constant. For instance, if the price of Ether increases to 400 DAI, then the equation would adjust to 5 Ether and 2000 DAI to keep the K value constant at 10,000.
However, when you provide liquidity to a pool, you are exposed to impermanent loss, which is the difference between the value of your assets if you had simply held onto them versus depositing them into the liquidity pool. The starting token balance is the value of the assets you deposited, while the ending token balance is the value you would withdraw at any given moment.
Can you show me an Example?
Let's say you provided liquidity to a pool with 1 Ether and 100 DAI, with Ether being token A and DAI being token B. Your starting token balance would be (1 * 100) + (100 * 1) = $200.
If the price of Ether increases to 400 DAI and your asset is still in the liquidity pool, your 10% liquidity share would now translate to 0.5 Ether and 200 DAI in order to keep the liquidity pool balanced. Therefore, your ending token balance would be (0.5 * 400) + (200 * 1) = $400. This means that you made a profit of $200, which is the difference between your starting and ending token balance, plus any trading fees earned.
However, if you had simply held onto your assets, your ending token balance would be (1 * 400) + (100 * 1) = $500. This is a loss of $80, which is classified as impermanent loss.
To avoid impermanent loss, you can consider providing liquidity to pairs with less volatility or by hedging your position. Additionally, you can also consider providing liquidity with stablecoins, which are less prone to price fluctuations.
Is there anything I can do to avoid impermanent loss?
To avoid impermanent loss, the easiest way is to hold onto your assets instead of providing liquidity.
However, providing liquidity can potentially lead to returns, so if you're willing to take the risk, you cannot completely avoid impermanent loss. Nonetheless, there are some tips to reduce your exposure to it.
One way is to use stablecoins. Impermanent loss is more likely to occur with volatile assets than with stable ones. Therefore, it might be best to avoid volatile assets when providing liquidity and stick with stable tokens such as stablecoins.
Another way to reduce your exposure is to start with small amounts and gradually increase your investment as you learn more about the market. By doing so, you can diversify your assets and reduce your loss exposure.
It's important to understand your risk tolerance and only invest money that you can afford to lose. Investment requires prudence, so determine how much risk you're willing to take before providing liquidity.
Finally, you can reduce your exposure to impermanent loss by using reliable market makers. Ensure that your Automated Market Makers are trustworthy, so you don't fall prey to manipulators.
Conclusion
In this article, you learned about impermanent loss, a risk faced by liquidity providers in decentralized finance. Impermanent loss occurs when there's a significant change in the price of tokens deposited into liquidity pools, and it can affect the profits earned by liquidity providers.
Impermanent loss is called "impermanent" because the loss is only recorded if you withdraw your funds from a liquidity pool when the token values are experiencing a significant drop. If you wait until the prices return to their previous levels before withdrawing, you don't have to lose anything.
Additionally, you saw how to calculate impermanent loss using the constant equation x * y = K, which is used to maintain the balance of tokens in liquidity pools.
Finally, you were shown some tips on how to avoid or reduce the impact of impermanent loss, such as using stablecoins, starting with small amounts, understanding your risk tolerance, and using reliable market makers.
Understanding impermanent loss and its potential impact on your profits is crucial for participating in decentralized finance as a liquidity provider. By being aware of the risks and taking measures to mitigate them, you can make more informed decisions and navigate the world of decentralized finance more effectively.
