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Impermanent Loss: What You Need to Know Before Providing Liquidity
If you are interested in decentralized finance (DeFi), you may have heard of liquidity pools. These are smart contracts that allow users to deposit their tokens and earn fees from trading activity. Liquidity pools are essential for the functioning of automated market makers (AMMs), such as Uniswap, SushiSwap, or PancakeSwap, which enable anyone to trade tokens without intermediaries.
However, while high-interest rates are offered as a potential upside, liquidity pools offer a sometimes unknown downside risk known as impermanent loss. In this article, we will explain exactly what impermanent loss is, provide an easy-to-follow example and outline the steps investors can implement to mitigate the risk.
What is Impermanent Loss?
Impermanent loss happens when you provide liquidity to a 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.
Impermanent loss is usually observed in standard liquidity pools where the liquidity provider (LP) has to provide both assets in a correct ratio, and one of the assets is volatile in relation to the other, for example, in a Uniswap DAI/ETH 50/50 liquidity pool. If ETH goes up in value, the pool has to rely on arbitrageurs continually ensuring that the pool price reflects the real-world price to maintain the same value of both tokens in the pool. This basically leads to a situation where profit from the token that appreciated in value is taken away from the liquidity provider.
At this point, if the LPs decide to withdraw their liquidity, the impermanent loss becomes permanent.
How Does Impermanent Loss Happen?
Let's use a simple example to illustrate how impermanent loss can affect a liquidity provider.
Bob deposits 0.5 BTC and 10,000 USDT in a liquidity pool. The pool requires that the value of both assets be equal, so the price of BTC is 20,000 USDT at the time of deposit. The total value of Bob’s deposit is 20,000 USDT. The pool has a total of 5 BTC and 100,000 USDT, so Bob owns 10% of the pool.
The price of BTC rises on an external exchange like Binance. Now Binance’s BTC price is 40,000 USDT. An arbitrageur sees this price difference and decides to exploit it for profit.
The arbitrageur buys cheaper BTC from the pool until the pool price matches the external price. To do this, the arbitrageur uses the constant product formula that governs the pool’s behavior: x * y = k, where x is the amount of BTC, y is the amount of USDT, and k is a constant.
By plugging in the external price into this formula, we can find out how much BTC and USDT will be left in the pool when the prices are equal: 4 * 160,000 = k, so k = 640,000.
So the arbitrageur buys 1 BTC from the pool for 80,000 USDT, achieving an average price of 36,000 USDT per BTC.
The arbitrageur can then sell this BTC on Binance for 40,000 USDT, earning a profit of ~4,000 USDT minus fees.
What happened to Bob’s deposit? He still owns 10% of the pool, which means he now has:
- 0.4 BTC
- 16,000 USDT
If he sold his share right now he would get:
- 0.4 * 40,000 + 16,000 = ~32,000 USDT
That’s not bad! He made 12,000 USDT in profit!
However, if he didn’t provide any liquidity and just held on to his assets he would have:
- 0.5 BTC
- 10,000 USDT
Which would be worth:
- 0.5 * 40,000 + 10,000 = ~30,000 USDT
That’s a difference of ~2,000 USDT!
This difference is what we call impermanent loss.
How Can You Avoid Impermanent Loss?
There are a few ways you can reduce or avoid impermanent loss when providing liquidity:
- Choose pools with less volatile assets: Pools that contain assets that remain in a relatively small price range will be less exposed to impermanent loss. Stablecoins or different wrapped versions of a coin, for example, will stay in a relatively contained price range.
- Choose pools with higher trading fees: Even if you are exposed to impermanent loss, you can still earn profits from trading fees. Some protocols charge higher fees than others or have dynamic fee models that adjust according to market conditions.
- Choose pools with incentives: Some protocols offer additional rewards for providing liquidity, such as governance tokens or yield farming opportunities. These rewards can offset or even surpass any potential losses from impermanent loss.
- Hold your liquidity for longer: Impermanent loss is only realized when you withdraw your liquidity from
the pool. If you believe that the prices will eventually return to their original levels or that your trading fees and rewards will outweigh your losses over time, you can choose to hold your liquidity for longer.
Impermanent loss is one of the risks associated with providing liquidity to AMMs. It occurs when the prices of your deposited assets change relative to each other and create an opportunity for arbitrageurs to profit from your loss.
However, impermanent loss can be mitigated or even overcome by choosing pools with less volatile assets, higher trading fees, incentives or holding your liquidity for longer. Providing liquidity can be a rewarding venture if you understand the risks and benefits involved and make informed decisions based on your risk appetite and goals.
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