Summary

If you have participated in DeFi projects, you must have heard of this term. Impermanent loss occurs when the price of the tokens you hold changes compared to when they were deposited into the pool. The larger the price difference, the greater the impermanent loss.

What? Providing liquidity will also result in losses? Why is this loss said to be impermanent? In fact, it comes from the inherent design characteristics of a special market - automated market makers. Providing liquidity to the liquidity pool is indeed profitable, but we must always pay attention to the concept of "impermanent loss".


Introduction

The volume and liquidity of DeFi protocols such as Uniswap, SushiSwap or PancakeSwap have exploded. With these liquidity protocols, any fund holder can become a market maker and earn transaction fees. The democratized market making mechanism makes many economic activities in the digital currency field more harmonious.

So, what do you need to know before providing liquidity to these platforms? In this article, we will discuss one of the most important concepts - impermanent loss.


What is impermanent loss?

Providing liquidity to a liquidity pool may incur impermanent loss. This is when the price of the deposited asset changes from when it was deposited. The greater the change, the higher the probability of incurring impermanent loss. In this case, impermanent loss means that the value of the USD at the time of withdrawal is less than the deposited value.

If the prices of the assets in the pool are within a relatively small range of change, the risk of impermanent loss will be reduced. For example, different anchored versions of stablecoins or tokens will be within a relatively stable price range. In this case, the liquidity provider (LP) is less likely to suffer from impermanent loss.

Why do liquidity providers still provide liquidity when they know that they may suffer from impermanent loss? In fact, impermanent loss can be offset by transaction fees. In fact, even for a fund pool like Uniswap that is prone to impermanent loss, users can still make a profit through transaction fees.

Uniswap charges a 0.3% fee on every trade conducted directly with liquidity providers. If a given pool has extremely high volume, providing liquidity to it can still be profitable even in the face of huge impermanent losses. However, this depends on the protocol, the specific pool, the assets deposited, and even a variety of market environmental factors.


How does impermanent loss arise?

Let’s use an example to illustrate how impermanent loss suffered by liquidity providers arises.

Alice deposits 1 ETH and 100 DAI in the liquidity pool. In this special automated market maker (AMM) mechanism, the deposited token pair needs to consist of two tokens of equal value. This means that at the time of depositing the tokens, the price of 1 ETH is equal to 100 DAI. At this point, Alice's assets are worth $200 at the time of deposit.

In addition, there are 10 ETH and 1,000 DAI in the fund pool (the remaining funds are provided by the same liquidity provider as Alice). Therefore, Alice has a 10% share in the fund pool, and the total liquidity is 10,000.

Suppose the price of ETH rises to 400 DAI. In this case, arbitrage traders inject DAI into the pool and remove ETH until the ratio reflects the current price. Note that the AMM mechanism does not use an order book. What determines the price of the assets in the pool is the proportion of the different assets in the pool. While the overall liquidity remains the same (i.e. 10,000), the ratio of the assets in the pool has changed.

If the price of ETH becomes 400 DAI, the ratio of the two tokens in the pool will change accordingly. Due to the operations of arbitrage traders, there are now 5 ETH and 2,000 DAI in the pool.

If Alice decides to withdraw her funds, as we learned earlier, she is entitled to a 10% share of the pool. Therefore, she can withdraw 0.5 ETH and 200 DAI, with a total value of $400. Compared to the $200 she deposited, she has undoubtedly made a considerable profit. However, what would have happened if she had held on to 1 ETH and 100 DAI? The total value of these assets would have risen to $500.

It turns out that Alice can earn more by holding these assets than by depositing them into the liquidity pool. This is known as "impermanent loss". In the above case, Alice's losses are small and her initial deposit is relatively small. However, it is important to note that impermanent loss can lead to significant losses (even including most of the initial deposit).

That being said, this example completely ignores the transaction fees Alice earned by providing liquidity. In many cases, the fees earned can offset the losses and the liquidity provider can still make a profit. Even so, before providing liquidity to DeFi protocols, it is important to understand the important concept of impermanent loss.


Impermanent loss estimation

Impermanent loss occurs when the price of an asset in the pool changes. How is the exact amount of loss calculated? We can plot it in a chart. Note that this chart does not take into account the transaction fees earned by providing liquidity.

Impermanent loss chart


From this chart, we can see the loss caused by price changes compared to simply holding the coins:

  • 1.25 times the spread = 0.6% loss

  • 1.50 times the spread = 2.0% loss

  • 1.75 times the spread = 3.8% loss

  • 2 times the spread = 5.7% loss

  • 3 times the spread = 13.4% loss

  • 4 times the spread = 20.0% loss

  • 5 times the spread = 25.5% loss

There are some important things you need to know. Impermanent loss occurs regardless of how the spread moves. It exists as long as the price changes from when you deposited. If you want to learn more about this, check out Pintail’s article.


The risks of providing liquidity to automated market makers

Actually, the term “impermanent loss” is a misnomer. It is so named because the loss does not materialize until the tokens are withdrawn from the liquidity pool. From that point on, the impermanent loss largely turns into permanent loss. The trading fees you earn may cover such losses, but the name is still a bit misleading.

Providing liquidity to an automated market maker (AMM) requires extreme caution. As discussed above, some liquidity pools are more susceptible to impermanent loss than others. Simply put, the more volatile the assets in the pool are, the higher the probability of impermanent loss. In the beginning, we recommend depositing only a small amount of funds. This way, you can take it one step at a time and roughly estimate the expected returns before investing more funds.

The last point is to find more tried and tested AMMs. DeFi projects allow any participant to easily fork existing AMMs and add some minor changes. However, this may expose you to serious mistakes, causing your funds to be stuck in the AMM forever. If a liquidity pool promises an abnormally high rate of return, there may be some drawbacks somewhere else, and the corresponding risks will be higher.


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Summarize

Impermanent loss is one of the fundamental concepts that anyone looking to provide liquidity to an automated market maker (AMM) should understand. Simply put, if the price of a deposited asset changes from the time it was deposited, the liquidity provider is at risk of experiencing impermanent loss.

Do you have any other questions about impermanent loss or slippage? Visit Ask Academy, our Q&A platform, where Binance community members will patiently answer your questions.