So far, the emergence of Decentralized Finance (DeFi) has created a plethora of opportunities for cryptocurrency investors to earn interest in their assets. However, those who have hopped on this DeFi rollercoaster are aware of the risks of these liquidity pools. There is a substantial financial risk involved. Among them would be the temporary loss that occurs because of supplying liquidity to DeFi. Impermanent Loss is a type of risk not found in Traditional Finance (TradFi) and any prospect DeFi user should learn about before jumping into liquidity provision.
What is Impermanent Loss?
In general, the impermanent loss represents a loss incurred when the value of deposited assets fluctuates between the time of deposit and the time of withdrawal. Only after withdrawing funds from a liquidity pool can the loss be determined.
Typically, the loss results from putting two distinct cryptocurrencies into an automated market maker (AMM) based liquidity mechanism, such as the one found in Unsiwap, Trader Joe, etc. Automated market makers allow trades on decentralized exchanges (DEXs) by leveraging liquidity pools instead of market makers and takers in a conventional order book structure. Consider them to be the trading engine for DEXs. Although AMM users give liquidity to the pools, the values of cryptocurrencies are determined by a mathematical formula, which might fluctuate based on the AMM.
Simply, when you provide liquidity to a certain pool, you get back liquidity pool tokens that represent your percentage share of the pool. You do not own anymore your tokens, but a percentage of the pool.
When you remove your assets from an AMM liquidity pool at a later date with a substantial value difference, you will incur a loss. The distinguishing moniker of impermanent loss alludes to the fact that it is only discernible after funds are withdrawn from a liquidity pool.
Any predicted loss on the assets in a liquidity pool would exist only on paper prior to withdrawal. Depending on the market’s direction, the losses may vanish totally or diminish by a substantial amount over time.
Impermanent Loss in Practice
Let’s explore the practical aspects of impermanent loss by looking at a concrete example.
Imagine that you deposit 1 ETH token and 100 USDC tokens into a liquidity pool. Let us begin by making a few assumptions:
We must supply liquidity to both sides of a typical pool, for which we are providing liquidity. This indicates that we must deposit equal quantities of each token in the pair. Furthermore, we will assume that 1 ETH token is equivalent to 100USDC tokens at the moment of deposit – USDC is a dollar-pegged stablecoin of 1$.
At the moment of deposit, the total value will be $200 based on the abovementioned assumptions. Let us additionally suppose that other LPs have previously contributed 9 ETH tokens and 900 USDC tokens to the pool. In this instance, we have a 10% stake in the pool, which has total liquidity of $2,000.
If the price of 1 ETH token grows to the equivalent of 400 USDC tokens, the proportion of ETH tokens to USDC tokens in the pool will change. Consequently, the pool now contains 5 ETH tokens and 2,000 USDC tokens.
Even if we withdraw our cash, we are still entitled to a 10% part in the pool. As a consequence, we may now withdraw $400, comprised of 0.5 of token ETH and $200 of token USDC.
Evidently, we have gained some profit since our first investment of $200 worth of tokens, but what if we had just hung on to our 1 token ETH and 100 tokens USDC? If we had merely retained the tokens, we would have had a total of $500.
Instead of depositing into the liquidity pool, we would have been better off keeping. The difference of $100 represents the temporary loss.
Worthy of note, when liquidity providers deposit their funds in a pool, they also earn a percentage of fees collected from the pool when traders exchange assets. In addition, sometimes AMM DEXes may provide additional rewards to liquidity providers to attract liquidity. Depending on the duration you have your funds deposited in the pool as well as the price change during this period, these rewards may or may not compensate for the impact of impermanent loss.
Additional Considerations about Impermanent Loss
Loss may occur regardless of the direction of the price. In the preceding math example, we raised the price of ETH and demonstrated how impermanent loss reduced profits relative to digital assets held in a wallet. However, impermanent loss happens regardless of whatever asset is moving in the cryptocurrency pair. A liquidity provider may only withdraw digital assets that have not experienced an impermanent loss if the exchange rate is the same at the time of withdrawal.
Furthermore, an impermanent loss is only realized upon withdrawal of cash. It is “impermanent” because prices might revert at any moment to the original exchange rate. If prices recovered, the impermanent loss would cease to exist. If an investor withdraws their cash from the liquidity pool, then the loss is irreversible.
Methods to Prevent Impermanent Loss
How can we combat impermanence loss now that we understand what it is? In many liquidity pools, impermanence loss is an unavoidable fact, but there must be a set of techniques that may be used to mitigate or even eliminate its effects.
Avoid volatile liquid asset pools
Overall, the value of cryptocurrency assets such as ETH is not connected to the value of external assets such as stablecoins, hence it fluctuates with market demand. Opt for trading pairings that use stablecoins to prevent the risk of impermanent losses. For the purpose of impermanent loss mitigation stablecoins or assets of a comparable value such as ETH/bETH or AVAX/sAVAX may be used. Assets of similar value are often the same assets represented with two tokens. This may be the result of bridging the assets from several bridges or the use of liquid staking methods.
Worthy of note, even two assets that are meant to have the same value can potentially change values dramatically due to smart contract hacks and exploits (in the case of bridges), or as we’ve seen in the case of Terra’s UST, due to a failed design.
Impermanent Loss Protection offered by AMM DEXes
Impermanent loss protection is a feature usually offered by some Decentralized Exchanges. Elk Finance and Bancor are two examples of exchanges that provide impermanent loss protection for their users. In situations like these, the protocol will often, upon withdrawal, issue a set amount of “reward” in the form of their native token. This is done to compensate, in whole or in part, for the impermanent loss value.
Impermanent loss challenges the promise of AMMs as a method for democratizing liquidity supply and allowing passive market-making by any user with idle cash.
For any new DeFi user that is impressed by the high yields, many decentralized exchanges offer, make sure you understand the various risks associated with liquidity provision, especially impermanent loss, before jumping into the liquidity provision game.