In brief

If you have ever participated in the DeFi market, you have certainly heard this term. Impermanent loss occurs when the price ratio of deposited tokens changes, after you deposit them into the liquidity pool. The greater the change, the greater the temporary loss.

So, can you lose money by providing liquidity? Also, why is this loss temporary? The reason is the inherent inherent nature of the design features of automated market-making tools. Providing liquidity to a liquidity pool can be a profit-generating venture, but you will need to keep in mind the concept of impermanent loss.


Introduce

DeFi protocols like Uniswap, SushiSwap, or PancakeSwap have seen an explosion in volume and liquidity. These liquidity protocols essentially allow anyone who owns cryptocurrency to become a market maker and earn trading fees. The democratization of market making has enabled a lot of frictionless economic activity to take place in the cryptocurrency market.

So, what do you need to know if you want to provide liquidity to these platforms? In this article, we will discuss one of the most important concepts - temporary loss.


What is temporary loss?

Impermanent losses occur when you provide liquidity to the liquidity pool and the price of your deposited assets changes compared to when you first started depositing. The larger this change, the higher the temporary loss. In this case, the loss is calculated in less dollar value at the time of withdrawal than at the time of deposit.

Asset pools with small spreads are less susceptible to temporary losses. For example, stablecoins or various wrapped versions of cryptocurrencies will stay in a relatively stable price range. In this case, the risk of temporary loss will be relatively small for liquidity providers (LPs).

So, why do liquidity providers still provide liquidity when they could face potential losses? In fact, the temporary loss can be compensated by the transaction fees they receive. In fact, although pools on Uniswap often experience temporary losses, users can still profit by enjoying transaction fees.

Uniswap charges 0.3% per trade directly and sent to liquidity providers. If there is a lot of trading volume occurring in a certain pool, it can be profitable even if the pool is damaged by temporary losses. However, this depends on the protocol, specific pools, deposited assets, and even broader market conditions.


How does temporary loss occur?

Let's take a look at an example of how a temporary loss occurs with a liquidity provider.

Alice deposits 1 ETH and 100 DAI into the liquidity pool. In this particular automated market maker (AMM), the deposited pair of tokens must be of equivalent value. This means the price of ETH was 100 DAI at the time of deposit. This also means that the USD value of Alice's deposit is 200 USD at the time of deposit.

Additionally, there are a total of 10 ETH and 1,000 DAI in the pool - contributed by other liquidity providers like Alice. So Alice has 10% of the group's shares and total liquidity of 10,000.

Let's say the price of ETH increases to 400 DAI. When this happens, arbitrage traders will add more DAI to the pool and withdraw ETH from it until the ratio accurately reflects the price. Remember that AMM does not have an order book. What determines the price of the assets in the pool is the ratio between them in the pool. While liquidity has remained constant within the pool (10,000), the proportion of assets within it has changed.

If ETH is currently priced at 400 DAI, this means that the ratio between ETH and USDT prices in the pool has changed. There are now 5 ETH and 2,000 DAI in the pool, thanks to the work of arbitrage traders.

So, Alice decided to withdraw her money. As we saw earlier, she is entitled to 10% of the pool's shares. As a result, she received 0.5 ETH and 200 DAI, for a total value of 400 USDT. She has made some significant profits since she deposited 200 USD worth of tokens, right? But wait, what if she only holds 1 ETH and 100 DAI? The total US dollar value of these holdings would be $500 at this time.

In fact, Alice could have earned more if she had just HOLD the coins in her wallet, instead of placing them in the Uniswap pool. This is the phenomenon we call temporary loss. In this case, Alice's loss is negligible because the initial deposit was a relatively small amount. However, remember that a temporary loss can lead to a large loss (a significant part of the initial deposit).

As in the example, Alice is completely indifferent about the transaction fees she will earn for providing liquidity. In many cases, the fees earned cover losses and generate profits for the liquidity provider. Even so, it is important to understand transient loss before providing liquidity to a DeFi protocol.


How to estimate temporary loss

In short, temporary losses occur when the prices of assets in the liquidity pool change. But how much is it exactly? We can illustrate this on a graph. Note, this chart does not include the fees that liquidity providers earn for providing liquidity.

Biểu đồ tổn thất tạm thời


Here's a summary of what the chart tells us about losses when providing liquidity versus HODLing:

  • Price change 1.25 times = 0.6% loss

  • Price change 1.50 times = 2.0% loss

  • Price change 1.75x = 3.8% loss

  • Price changes 2 times = 5.7% loss

  • Price changes 3 times = 13.4% loss

  • Price change 4 times = 20.0% loss

  • Price change 5x = 25.5% loss

There is one important thing you also need to understand. Impermanent losses occur whenever prices change in any direction. The only thing that impermanent losses care about is the ratio of asset prices compared to the time of deposit. If you want a more detailed explanation of this issue, you can read Pintail's article on Medium to learn more about it.


Risks when providing liquidity to AMM

To be honest, temporary loss is not a great name. It is called a temporary loss because the loss only materializes when you withdraw your funds from the liquidity pool. However, at that point, the temporary loss will become a permanent loss. The fees you earn may make up for those losses, but it's still a misleading name.

Be very careful when you deposit money into an AMM . As we have discussed, some liquidity pools suffer more temporary losses than others. As a simple rule of thumb, the more volatile the assets in the pool, the more likely you are to incur temporary losses. So, it's better to start by depositing a small amount. This way, you can get a rough estimate of the profits you might have before committing to depositing a more significant amount.

The final point is to look for more AMMs and experiment with them. DeFi makes it quite easy for anyone to fork an existing AMM and add some small changes to it. However, this can introduce errors, and it can potentially leave your funds stuck in the AMM forever. If a liquidity pool promises unusually high returns, there may be trade-offs involved, and the risks involved may also be higher.


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summary

Impermanent loss is one of the fundamental concepts that anyone looking to provide liquidity to AMMs should understand. In short, if the price of the asset changes since deposit, the liquidity provider may suffer temporary losses.

Do you still have questions about temporary loss or slippage? Follow our Q&A platform - Ask Academ. The Binance community will answer you.