Many people involved in DeFi want to know the answer to the question, “What is impermanent loss?”, DeFi protocols have experienced a surge in volume and liquidity. The liquidity protocols allow anyone with funds to become a market maker and earn trading fees.
The protocols have enabled seamless economic activity in the crypto space by making market-making available to a wider audience. But, if you want to provide liquidity for such platforms, you must be familiar with impermanent loss.
Fortunately, this guide will provide you with all the information you need. Let’s start.
What Is Impermanent Loss?
When you add funds to a liquidity pool, and the price of your assets changes from when you added them, impermanent loss happens. This means you will get back less money in dollars when you withdraw than what you put in. It occurs when the market price of a token shifts, causing your assets in the liquidity pool to be worth less than their current market value.
Liquidity pools are integral to the operation of automated market maker platforms, or AMMs, which enable users to trade between assets without requiring a traditional central order book. When liquidity providers (LPs) deposit several tokens into a pool, they make assets available for other protocol users to trade against.
Tokens are locked into a smart contract and contributed to a liquidity pool, so LPs can’t use the locked assets for other trading purposes while being committed to the liquidity pool.
Still, because of the AMM mechanism and volatile asset prices, an asset’s value locked in a liquidity pool can drop if the LP holds the asset and doesn’t provide liquidity, a price discrepancy referred to as impermanent loss.
How Does Impermanent Loss Work?
When answering what impermanent loss is, we mentioned that it happens because of constant liquidity pool rebalancing caused by shifts in market price.
To better understand how impermanent loss works, let’s take an example:
Suppose a trader offers liquidity to a token pair pool consisting of equal ETH amounts and a newly launched altcoin. At first, both paired assets have equal value. But, as time passes, ETH’s price increases compared to the altcoin. Due to crypto arbitrage and liquidity pool algorithms, the proportion of the assets in the pool changes.
If liquidity is withdrawn from the pool when the price of ETH is higher, the trader will get more of the altcoin and less ETH than they initially deposited. This difference between the initial deposit value and the value at the time of the withdrawal is an impermanent loss.
The ‘impermanent’ part of the term refers to the change of the token value in relation to each other; there’s only a loss if the trader withdraws the assets from the pool at that time.
Impermanent Loss Calculation
Now that you have learned what impermanent loss in a liquidity pool is, let’s explain how to calculate it. Investors should first calculate the relative value to calculate impermanent loss and project the potential for permanent loss.
That’s done by dividing the invested assets’ current value by the initial value of the same assets and then comparing the relative value to the external market returns. So, the investor can get a rough idea of the potential loss through the difference between the two values.
Let’s take an example to understand better how to calculate impermanent loss: Suppose that Kate contributes $1,000 worth of Token X and $1,000 worth of Token Y to a liquidity pool. At first, the assets’ value is $2,000. Let’s say that over time, Token X’s price increases by 50% while Token Y’s price stays the same. The ROI for Token X would be 100%, whereas for Token Y, it would be 0%. So, now, Kate has a Token X worth $2,000 and a Token Y worth $1,000, making her total assets worth $3,000, with the average external market return for both tokens being 50% (the average of 100% and 0%). If Kate wants to find the relative value of her invested assets, she needs to check their current value in the liquidity pool. She can divide $3,000 (the current value of her assets) by $2,000 (the initial asset value) to get her investments’ relative value to 1.5 or 150%. Ultimately, she should compare 150% (the relative value) to 50% (the average external market return). She will get a 100% (150-50) difference between the two values, meaning that this investment’s impermanent loss is 100%. At the same time, this translates to a 100% potential for permanent loss if Kate withdraws her tokens at the wrong time. What’s worse, this can also mean that Kate’s asset value would have increased by 100% if she kept the tokens in her wallet rather than investing them in a liquidity pool. We hope these impermanent loss examples have painted a clearer picture for you to understand the concept.Example
How to Use an Impermanent Loss Calculator
People who want to estimate the potential loss when providing liquidity to a specific pool can use impermanent loss calculators. These calculators typically consider many factors, such as the pool composition, initial asset prices, and price changes over time.
Let’s explain how the CoinGeico impermanent loss calculator works:
- Choose the AMM model.
- Set Asset 1’s percentage price change.
- Select a weightage for Asset 1.
- Set Asset 2’s percentage price change.
- Select a weightage for Asset 2 using the automatic setting or customization.
The Relationship Between Impermanent Loss and Volatility in the Crypto Market
Market volatility is a major factor in impermanent loss. During periods of high volatility, the market prices of assets deposited in a liquidity pool can change.
These price shifts may be caused by factors such as a project forming new partnerships, reaching a specific roadmap milestone, experiencing specific negative outcomes, or affecting the project’s future outlook.
Traders should consider the volatility of the assets in which they provide liquidity since high-volatile assets can lead to higher impermanent loss.
What Can Influence Impermanent Loss in Crypto and How to Avoid It?
Let’s first talk about the leading causes of impermanent loss.
Crypto Price Volatility
If you want to know what impermanent loss is in DeFi, you should also know about its most common cause: crypto price volatility. Impermanent loss occurs if the price of your deposited assets changes and is not the same as when you deposited them.
In other words, a token’s price can change in the market, resulting in your deposited assets in the liquidity pool being worth less than their present value in the market.
So, high-volatile assets can lead to higher impermanent loss. As mentioned, price can change due to many factors, like when a project reaches a new milestone, when it is negatively associated, when new partnerships arise, and so on.
Liquidity Pool Composition
When pools have stablecoin pairs or assets of high correlation, they usually face lower levels of impermanent loss. For example, ETH and WBTC have an almost 90% price correlation, meaning they tend to move up and down simultaneously and by similar amounts.
Using stablecoins is even safer, as they are pegged to $1. To assess the potential risks involved, it’s crucial to understand the dynamics of the assets within the pool and what impermanent loss in crypto is.
Time Horizon
Time can have different effects on impermanent loss. For instance, waiting long for some pools may help the pool regain a closer balance and minimize or eliminate the impermanent loss. Then again, waiting can worsen the situation, especially for assets that are either increasing significantly or dropping to zero.
Trading Volume
Trading volume affects impermanent loss, as increased selling pressure or demand can make the price deviate, resulting in the impermanent loss. Your pool can also face loss faster due to increased volume, leaving you insufficient time to observe trading metrics for your pool.
Several strategies can help you avoid impermanent loss:
Conclusion
So, what is impermanent loss? It occurs when you provide liquidity to a liquidity pool and the price of your deposited assets is not the same as when you deposited them. Investors should first calculate the relative value to calculate impermanent loss and project the potential for permanent loss.
The price volatility, the pool’s composition, the time horizon, and the trading volume primarily influence impermanent loss. Some strategies to avoid it are using multiple pools, observing prices and market trends, and choosing stablecoin pairs.