Decentralized Finance (DeFi) has become an important sector in the blockchain space, with industries moving to programmable and permissionless services. Per estimates, the global DeFi market is expected to surge significantly in the next three years, growing at an annual rate of 43.8%.
The DeFi ecosystem allows investors to trade automatically without using brokers. The underlying protocol that enables this phenomenon is the automated market maker (AMM), which also provides liquidity to the system. Liquidity pools can suffer impermanent loss if the value of a token in a liquidity pool diverges from its value before being deposited. This loss can occur due to several factors. Hence, understanding this phenomenon can help a liquidity provider minimize impermanent loss.
What is Impermanent Loss?
Impermanent loss is a temporary loss experienced when the price of an asset changes relative to its original value in a liquidity pool. Simply put, IL is the difference between the value of assets placed in a liquidity pool versus what the liquidity provider would have had if held in a wallet.
For example, if a user puts $100 worth of assets in a liquidity pool and it decreases to $90, then they have suffered an impermanent loss. However, this loss can be minimized if the price of the asset reverts to its initial value. Hence, the loss is called “impermanent.”
What are Liquidity Pools
Liquidity pools are smart contracts that act as a decentralized pool of funds where LPs (liquidity providers) can deposit crypto assets. In turn, traders transact these assets within the pool without using a centralized third party. When a liquidity provider supplies the pool with a trading pair, they earn a portion of the fees generated during the trade.
The value of the asset deposited by an LP is relative to the supply and demand of the tokens in the pool. For example, a pool might have ETH and USDC. People trade ETH for USDC and vice versa using this pool. If someone buys ETH with USDC, they take ETH out of the pool and add USDC. This changes the ratio, and therefore the price goes up. Similarly, if they sell ETH for USDC, the price goes down.
How Does Impermanent Loss Occur?
DeFi liquidity pools oftentimes use AMMs to adjust the ratio of the assets in the pool. This automated algorithm helps users trade their tokens against liquidity held in the smart contracts. It also helps to adjust and balance the overall value of the tokens based on real-time trading actions. During trades, the number of assets in a pool changes, which can lead to impermanent loss.
Here is an example of how to calculate impermanent loss:
Step 1: Providing Liquidity
To start, a liquidity provider deposits 5 ETH, each worth $2,000, bringing the total value to $10,000. In addition, they put 10,000 USDT worth $10,000 into the pool. At the start, the total asset worth stands at $20,000.
Now the AMM uses this rule:
ETH amount × USDT amount = constant
So: 5 × 10,000 = 50,000
5×10,000=50,000
This value (50,000) is locked in and will be used to keep prices balanced inside the pool.
Step 2: A Trade Happens
Someone comes to buy ETH using 2,000 USDT.
That means:
The pool will now have 12,000 USDT (10,000 + 2,000)
For balance, the pool must now reduce ETH to keep the product constant.
The AMM recalculates how much ETH should be left:
ETH left = 50,000 / 12,000 = 4.1667 ETH
So the buyer gets:
5 − 4.1667 = 0.8333 ETH
Now the pool has 12,000 USDT and 4.1667 ETH.
The price of ETH in the pool has increased since it’s in lesser quantity than USDT. AMMs track this supply and demand to determine the price impact.
Step 3: ETH Price Goes Up in the Market
Assuming the price of ETH rises to $3,000 in the market, impermanent loss will be calculated as follows:
Scenario A: If You Just HODL’d (Held):
If you didn’t provide liquidity and just kept your assets:
5 ETH × $3,000 = $15,000
10,000 USDT = $10,000
Total value = $25,000
Scenario B: If You Provided Liquidity
After the trade and ETH price increase, your pool has:
4.1667 ETH × $3,000 = $12,500
12,000 USDT
12,000 + 12,500 = 24,500
Step 4: Calculating the Impermanent Loss
To calculate the IP, compare the two totals:
HODL value = $25,000
Pool value = $24,500
Impermanent Loss =25,000−24,500= $500
Why Is There a Loss?
The ETH in the pool reduced after the asset. In that timeframe, the value of ETH in the market increased. Hence, the liquidity provider missed out on the potential they would have had by simply holding the asset. This value difference is called impermanent loss.
What Causes Impermanent Loss?
Impermanent loss can be caused by various factors such as:
- Market Volatility: Trading pairs with high volatility are more prone to impermanent loss as their prices fluctuate quickly.
- Price Fluctuation: If the price of an asset changes significantly in a liquidity pool, this imbalance can lead to an impermanent loss.
- Arbitrage Trading: Some traders can capitalize on the temporary price difference of an asset in different pools. This arbitrage can cause IP.
- Asset Type: Impermanent loss can happen if the number of volatile assets in a pool is greater than the number of more stable tokens.
- Overall Market Price: An asset’s price in the broader market can result in impermanent loss; a significant price difference tends to impact the extent of IP.
- Small Liquidity Pools: Volatility is more likely to affect small pools than larger ones.
- Wide Trading Range: If a trading range spreads widely, impermanent loss may occur. To minimize this, decentralized platforms like Uniswap allow LPs to adjust the asset trading range. No trades will be conducted once the fixed range is exceeded.
How to Minimize Impermanent Loss
Here are some key steps to take to mitigate impermanent loss:
- Use Stablecoins: Incorporating fiat-backed stablecoins as a trading strategy can help minimize IP, as these coins are pegged to stable assets. Pairing stablecoins with other volatile assets can help absorb the impact of impermanent loss.
- Choose a Favorable Liquidity Pool: When picking a liquidity for transacting, it is important to consider the volatility and amount of liquidity. Pools with lower volatility are likely to suffer impermanent loss. Furthermore, pools with high liquidity are less prone to IP.
- Spread Investment: Another way of minimizing impermanent loss is to diversify liquidity across multiple pools and trading pairs. Spreading investments can help balance profits and losses as volatility in one pool does not affect the overall portfolio.
- Monitor Portfolio With Automated Tools: Monitoring liquidity positions lets LPs check their portfolio performance in real time. This could help them make faster decisions in case of a sudden change in market conditions. For instance, a liquidity provider may notice that one pool is performing better than the other and proceed to rebalance the portfolio. Some popular tools to monitor liquidity include APY.vision, Yieldmonitor.io, and Revert. finance, and Pools. fyi.
Conclusion
Impermanent loss (IL) is an inherent risk in providing liquidity to a pool. Importantly, several factors, such as price movements and market volatility, can lead to IL. However, understanding the concept of impermanent loss can help a liquidity provider minimize this risk. ILs are often not significant, and liquidity providers can curb this risk by adopting the previously outlined steps.
