So, you’ve heard about DeFi and want to get involved in the action? That’s great! However, before you jump in, it’s important to be aware of the risks involved. One of the most common risks associated with DeFi is “impermanent loss.” In this article, we’ll learn what is impermanent loss is, how it works, and how to minimize it.
What Is Impermanent Loss?
First things first, let’s define what impermanent loss actually is. Essentially, impermanent loss occurs when you provide liquidity to a decentralized exchange (DEX) and the price of the tokens in the pool changes. This can happen when one token in the pool experiences a significant increase or decrease in value, causing the overall value of the pool to shift. The end result is that the value of your tokens in the pool is no longer equal to the value of the tokens you originally deposited.
The bigger the difference in price, the greater the exposure to impermanent loss. In the case of liquidity pools, the loss means a lesser dollar value at the time of withdrawing the asset than what it was at the time of depositing them. Pools containing stablecoins assets are obviously less susceptible to impermanent loss.
So if there is a potential for loss, why do liquidity providers still provide liquidity? Impermanent loss can be counteracted to a certain extent by trading fees. For example, Uniswap charges a fee of 0.3% on each trade going directly to liquidity providers. Thus, if there is a significant amount of trading volume in one pool, then it is profitable even if the pool has substantial exposure to impermanent loss.
How Does Impermanent Loss Occur?
First, let’s be clear on one point. Impermanent loss does not necessarily prevent liquidity providers from making a profit. The loss is tangible and noticeable only if the user or investor is withdrawing liquidity from the liquidity pool when there is a difference in the value of the assets when they are being withdrawn. Liquidity pools employ several strategies to offset impermanent loss, such as high fees, which can offset the loss and help make a profit. As a result, fees often help liquidity providers cover their impermanent loss, if any.
However, sometimes, there are considerable price differences where the profit fee may not cover the loss. In such a scenario, the user or liquidity provider may have gained more value had they HODL-ed the assets instead of using them to provide liquidity. Let’s look at an example where such a scenario plays out.
Impermanent Loss Process
Suppose you deposit 1 ETH and 100 DAI in a liquidity pool. In the case of the market maker on which the assets have been deposited, the token pair is required to be of equal value. This means the value of the ETH is 100 DAI at the time of making the deposit, putting the dollar value of your deposit at 200 USD at the time of depositing. Additionally, the pool comprises 10 ETH and 1000 DAI, all funded by other liquidity providers. This would give you a 10% share of the liquidity pool, with a total liquidity of 10,000.
Let’s assume the price of ETH then increases to 400 DAI. When this happens, it opens up opportunities for arbitrage traders. These arbitrage traders will add DAI tokens and remove ETH to balance the pool. This process will continue as long as the process reflects the current price. At this point, it is essential to remember that AMMs do not have an order book. Instead, the asset’s price is determined by the ratio between the assets in the pool. While the total liquidity in the pool (in this case, 10,000) remains stable, the ratio of the assets within the pool changes.
So now, if the value of 1 ETH is 400 DAI, the ratio between ETH and DAI in the pool has changed, meaning there is now 5 ETH and 2000 DAI in the liquidity pool. Now, if you decide to withdraw your funds, you are entitled to a 10% share from the pool. This means you can withdraw 0.5 ETH and 200 DAI, worth around $400. Now on the face of it, this looks like a pretty neat profit. However, what would have happened if you had not deposited the funds, and simply held the 1 ETH and 100 DAI? If you had done that, the dollar value of the assets would have been $500.
This means you would have been better hodl-ing your assets rather than depositing them into the liquidity pool. In this case, the loss was insignificant since the initial deposit was a small amount. However, remember that impermanent loss can lead to far more significant losses.
How To Calculate Impermanent Loss?
Impermanent loss is calculated by dividing the current value of invested assets by their initial value. Once this is done, you can compare the relative value with the value prevailing in the market. The difference between both values will give you an average idea of the potential loss.
How Can You Avoid Impermanent Loss?
You can never avoid impermanent loss. However, you can take some steps to minimize it.
The introduction of liquidity fees helps to offset impermanent loss. To mitigate impermanent loss, it is essential to allocate a predetermined percentage of liquidity fees to the liquidity pool. So, what are liquidity fees? As the name suggests, liquidity fees are charged to traders who participate in the liquidity pool. Once collected, a portion of the total liquidity fees is distributed to liquidity providers for their role in managing the pool. In most cases, the liquidity fee is enough to compensate for any impermanent loss incurred by traders. The higher the liquidity fee, the lower the impermanent loss.
Low Volatility Assets
The more volatile the asset, the higher the chance of impermanent loss. As a liquidity provider, you have control over the level of impermanent loss you experience by selecting less volatile assets. Choosing stablecoins like USDT, USDC, or DAI can significantly reduce the risk of impermanent loss. While these pairs may have fewer opportunities for arbitrage, they also come with lower risks. Always prioritize token pairs that minimize exposure to market instability, volatility, and impermanent loss, rather than those with a history of volatility.
Use Trusted AMMs
You can choose from several automated market makers (AMMs). Always ensure you use the most tried and tested AMMs to reduce exposure to any manipulation.
If you are a new investor, you must ensure that you start out by staking a small amount. It is also essential to diversify your portfolio so you can reduce the percentage of assets exposed to impermanent loss.
Liquidity providers must have a good grasp of several concepts, with impermanent loss being one of the most critical ones when providing liquidity to automated market makers. Though it can pose a significant problem, investors can take several steps to minimize the impact of impermanent loss on their assets, as we have covered earlier. We trust that our guide on impermanent loss has aided you in comprehending the subject more thoroughly.
Disclaimer: The content of this article is strictly for information purposes only. All of the opinions expressed in this article are not connected to CoinSmart and are not intended to provide you with investment advice. It is important that you do your personal research and/or consult an investment advisor to determine what is right for you.