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Impermanent Loss Simply Explained

Impermanent Loss is a momentary loss of assets provided to an Automated Market Maker (AMM). It occurs when the ratio of a token pair changes. Impermanent Loss is the difference between holding an asset and providing liquidity.

What is Impermanent Loss?

Impermanent Loss occurs when liquidity providers provide liquidity to an AMM pool. They deposit assets in the form of token pairs (e.g., ETH-DAI token pair). When the ratio of the token pair changes, impermanent Loss happens. That means the number of funds changes compared to the initial deposit. The more the ratio slips, the bigger the Loss.

Risk of Impermanent Loss

Impermanent Loss is one of the risks of interacting with DeFi protocols. The risk of Impermanent Loss depends on the volatility of the underlying token pair. For example, stablecoin pairs (e.g., USDC-DAI) only bear a minimal risk of Impermanent Loss. We can expect the ratio to stay the same.

Say you deposit 100 USDC and 100 DAI to a Uniswap pool. As long as both stablecoins peg to $1, you will always be able to withdraw 100 USDC and 100 DAI from the pool again.

If you deposit 1 ETH and 2000 DAI into a Uniswap pool, you are at risk of losing part of your deposited assets because ETH is volatile. When ETH goes up in value, the token pair ratio changes and you lose an amount of your initial deposit.

Rewards for Putting Your Money At Price Risk

Why do people even provide liquidity to Automated Market Makers? It wouldn’t make sense for them if there were no rewards.

Liquidity providers are rewarded for putting their money at price risk. That’s why trading fees compensate for Impermanent Losses. Even volatile trading pairs can be profitable thanks to the trading fees.

Uniswap v3 liquidity providers receive either 0.05%, 0.3%, or 1% of their responsible volume. That means the more volume they process, the more fees LPs earn. If lots of trading volume happens, trading fees can outweigh temporary losses. This is not always the case. Whether trading fees outweigh Impermanent Losses depends on several factors:

  • the market conditions,
  • how high trading fees are
  • Token prices

Example of Impermanent Loss

The best way to understand the problem is to read a simple example: Let’s assume that an LP provides liquidity to the ETH-DAI token pair. He deposits 5 ETH and 10,000 DAI into a Uniswap pool, which looks like this:

Example of Impermanent Loss

It’s important to mention that both sides of the token pair must be of the same value. That means both ETH and DAI need to be worth $10,000.

ETH is currently valued at $2,000 per coin. DAI is pegged to $1 because it’s a stablecoin. That means ETH is volatile while DAI’s price doesn’t move at all.

Remember: when a token pair is volatile, you temporarily lose funds!

Now, let’s assume that ETH goes up in price. It rises from $2,000 to $3,000 per coin. Because both sides must have the same value, the token pair ratio changes:

Example of Impermanent Loss

As you can see, we have less ETH deposited into the pool. As ETH’s price rises, liquidity providers temporarily lose part of their initially deposited assets. The higher ETH goes, the less ETH is left to withdraw.

That’s the price risk LPs take to earn trading fees. The more volatile the token pair, the higher the risk. If ETH went to $10,000 or beyond, you would leave very little ETH inside the liquidity pool. LPs need to ask themselves whether trading fees are worth it. The LP could have held spot ETH after all.

Possible Solutions to Impermanent Loss

As of today, there is no solution to the problem. If you provide liquidity to an AMM, you are – per definition – putting your funds at price risk. This doesn’t only apply to AMMs but also centralized order book exchanges. Any exchange needs market makers who provide liquidity.

Liquidity providers make sure that exchanges are liquid. In order book exchanges, liquidity providers buy and sell funds from the order book. If the price rises above or below the buy price, market makers also lose funds impermanently.

So, Impermanent Loss is not new – it’s a common problem; it’s especially painful in DeFi because crypto is such a volatile asset class. Hence, Impermanent Loss occurs.

Even though we have no solution today, we saw first attempts to avoid it. Uniswap recently introduced their third version trying to tackle Impermanent Loss. The most significant innovation of Uniswap v3 is the possibility for LPs to provide liquidity in a predetermined price range. This allows LPs to set stop-losses. That means LPs can avoid Impermanent Loss after a certain threshold. While v3 doesn’t solve the underlying problem, it helps LPs stop providing liquidity when Impermanent Loss gets too big.

Whether we will ever solve the problem is yet to be determined; however, it’s safe to say that we will have to deal with it over the following months and years.

Conclusion

DeFi users risk losing their assets “impermanently” when they provide liquidity to AMMs. When the token pair ratio changes, Impermanent Loss occurs. We cannot avoid it at this point. It’s one of the biggest problems in the DeFi space. While we have no solution today, there might be one in the future.

Impermanent Loss is the necessary risk for LPs to earn trading fees. Without risk, there is no reward. Often, trading fees compensate for it. This is especially true with stablecoin pairs. They are not subject to volatility.

All in all, you should always keep the risk of Impermanent in mind when you decide to provide liquidity to AMMs. But remember that the Impermanent Loss is always temporary. Even if you lose assets on paper, the token pair ratio might always return to its initial state.

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