Understanding Impermanent Loss in DeFi and How to Work with It
Demystify the concept of impermanent loss in DeFi with our beginner-friendly guide! Understand the risks and make informed decisions in your crypto journey.
Impermanent loss is a concept that beginners often find complex and difficult to understand. For anyone participating in the DeFi sector, knowledge, or at least familiarity, with impermanent loss is a must-have.
This article aims to provide a simple, beginner-friendly explanation of impermanent loss, regardless of your prior knowledge of DeFi. This guide will give you essential insights into what impermanent loss is, why it occurs, and how to work with it.
Key Takeaways:
- Impermanent loss occurs when the prices of assets in a liquidity pool diverge from each other. Unless realized, the loss is offset If the prices converge back together.
- The reason for impermanent loss resides within the AMM (Automatic Market Maker) algorithm, which automatically balances the value of assets in the pool.
- For liquidity providers impermanent loss results in worse financial loss than they would have suffered with the same assets simply held on a wallet.
- Impermanent loss can be minimized by using stablecoin pairs, one-sided liquidity, or insurance. Sufficient yield can be also a way of minimizing potential losses.
Quick Recap on Liquidity Pools
To fully grasp the concept of impermanent loss, we first need to understand the fundamental components of the DeFi ecosystem. Let's get this out of the way first and then we can continue directly with impermanent loss.
Liquidity Pools: These are pools of multiple tokens that are held within a smart contract. No central authority controls these pools and because of that, they are used for trading in a decentralized manner.
Tokens in these pools are “borrowed” from users (liquidity providers) in order to allow other users to trade them. Liquidity providers “lend” assets to the liquidity pool by providing equal value of multiple tokens. For example, a user could provide $50 worth of DAI together with $50 worth of ETH - gaining a total $100 stake in the liquidity pool. Liquidity providers gain a return on their investment in a share of treading fees generated by the liquidity pool.
The proportion of tokens in the pool needs to stay balanced (1:1 or 1:2, etc.) at all times. This is because the algorithm of the liquidity pool - Automated Market Maker (AMM) is estimating the price of each asset based on how much of the asset is in the liquidity pool.
Example: Let's suppose we have a pool ETH:DAI (1:1). If ETH starts quickly disappearing from the pool it is probably because a lot of people are buying ETH. This way there is less ETH in the pool, but because the value of both tokens has to be the same, the price per 1 ETH will get higher.
What is Impermanent Loss
Now that we have a basic understanding of how liquidity pools work, let's dive into the problem of impermanent loss.
Impermanent loss is an event that occurs on the side of liquidity providers - those who provide assets in liquidity pools are subjected to the risk of impermanent loss. It is a situation in which liquidity providers experience bigger financial loss in a liquidity pool than they would if they simply held those same assets in their wallets.
I know it may sound confusing at this point, but once we dig deeper the whole thing will become more clear. In simple terms, if a liquidity provider experiences impermanent loss, they would be better off just by holding those same tokens in a wallet. As the name suggests, the impermanent loss is not permanent and can easily return to the original state without liquidity providers having to realize any losses. As we will explain later, it all depends on the market price of those assets.
How and Why Does It Occur?
The reason for the impermanent loss is simple - the price of assets in the liquidity pool starts to differentiate from each other. One token goes up and the other goes down. If both tokens go in the same direction no impermanent loss occurs and the liquidity provider is happy.
Let's illustrate this situation with an example:
- A provider deposits $50 worth of a memecoin PEPE (30 million PEPE) together with $50 worth of ETH (0.03 ETH). Now they have a $100 stake in the PEPE:ETH liquidity pool.
- The price of PEPE starts to tank with a 50% price drop, while ETH slowly climbs up by 10%, creating a price difference.
- In the liquidity pool, the amount of PEPE is increasing as users are selling more and more for ETH. Simultaneously ETH is becoming more scarce in the liquidity pool, hence the price increase.
- The AMM is trying to keep the 50:50 ratio between PEPE and ETH by shifting your stake to 42 million PEPE (50% price drop) and 0.018 ETH (10% price increase). The total difference is 40 % - this means that 40% of your ETH was swapped for PEPE in the pool.
- The provider then decides to withdraw their stake from the liquidity pool, ending up with 42 million PEPE and 0.018 ETH instead of their original 30 million PEPE and 0.03 ETH. With the new prices, their PEPE value is now at $35, and their ETH value is at $33. A resulting total stake of $68.
Have they not deposited these funds into the liquidity pool, the final value would be $25 worth of PEPE and $55 worth of ETH. Total value at $80. The difference between the $68 from the liquidity pool and $80 from simple holding is the impermanent loss.
Working with Impermanent Loss
How to Protect Your Assets?
There are several strategies to mitigate the risk of impermanent loss, however, with a higher reward also comes a higher risk of impermanent loss.
- Choosing Stable Pools: You can reduce the risk by providing liquidity to pools with stablecoins or tokens whose prices are less volatile or likely to move together.
- Liquidity Provider (LP) Rewards: Some protocols offer LP rewards, or 'farming rewards', in addition to trading fees. These extra tokens can often offset any impermanent loss.
- Insurance Options: Some DeFi platforms offer insurance options to cover potential losses, including impermanent loss.
- Using Impermanent Loss-protected Pools: Certain DeFi projects are developing solutions that aim to mitigate the impact of impermanent loss, often involving complex mechanisms such as dynamic fees or rebalancing pools.
Impermanent Loss Calculators
You can calculate the impermanent loss risk based on your price estimation for both assets and decide whether it is worth it. However, for a more precise calculation of potential impermanent loss, several online tools, or 'Impermanent Loss Calculators', can be used.
These calculators allow you to input your token values and price changes to calculate the potential impermanent loss. However, these should be used as a guide only, as they may not take into account all factors, such as trading fees or specific pool mechanisms.
Concentrated Liquidity
Some innovative DEXs, like Uniswap V3 have implemented a mechanism called “concentrated liquidity”. This allows the liquidity providers to choose the price range in which they will be providing liquidity. Concentrated liquidity allows for a more efficient swapping, as some assets usually trade within narrow ranges (such as stablecoins).
Fees earned by liquidity provision are higher this way, but with that also comes a higher risk of impermanent loss. It is important to be aware of this trend because it often tends to cause confusion.
FAQs
How do you calculate impermanent loss?
You can calculate it yourself using the following formula: Impermanent Loss (%) = [1 - (|a2/b2 / a1/b1| ^ 0.5)] * 100. But it is usually much easier and faster to use an impermanent loss calculator tool, such as this from DailyDeFi. Remember that the calculation depends heavily on your ability to estimate future prices.
Can you hedge impermanent loss?
You can hedge impermanent loss by using stablecoin to stablecoin pairs, or other pairs of pegged assets. Another option is a single-sided liquidity provision available on certain DeFi platforms. Alternatively, you could use the yield from to liquidity pool to offset the potential losses, but this only works if the yield is sufficient and stable.
Should I stake in a liquidity pool?
Staking in a liquidity pool can be profitable, but it also comes with risks, including impermanent loss. It's crucial to understand these risks and the dynamics of the specific pool before deciding to provide liquidity. Consider factors such as the volatility of the tokens, the pool's trading volume, the fees it generates, and any additional rewards offered by the DeFi protocol.
How does impermanent loss work with stablecoins?
Impermanent loss is generally less of a concern in pools involving stablecoins because these coins are designed to maintain a stable value, usually pegged to a reserve like USD. If both tokens in the pool are stablecoins (e.g., USDT/DAI), impermanent loss would be minimal as the relative prices of the tokens wouldn't significantly change. However, if a stablecoin is paired with a volatile token, impermanent loss could still occur if the volatile token's price changes significantly.
