Carefully! Lots of text.
If you've worked with DeFi before, then you've probably come across this term. A volatile loss occurs when the price of the assets deposited changes relative to the price at the time of deposit. The greater the change, the greater the loss.
So, you can lose money by providing liquidity? And why is this loss called impermanent? The risk of loss arises from a market called an automated market maker (AMM). It is possible to make a profit for providing liquidity to the pool, but you should always be aware of the variable losses.
Introduction
At one time, DeFi protocols such as Uniswap, SushiSwap or PancakeSwap experienced significant growth in volume and liquidity. These liquidity protocols allow virtually anyone to become a market maker and earn commissions for trading. This democratization of the market has provided freedom to carry out economic activities in the crypto space.
What is important to know before providing liquidity to these platforms? In this article we will look at one of the most important concepts - impermanent loss.
What are impermanent losses?
An impermanent loss occurs when you provide cryptocurrency to a liquidity pool and the price of the deposited tokens changes since the moment of deposit. The larger the change, the greater the impermanent loss: in other words, when you withdraw your funds, you will receive fewer dollars than you deposited.
Pools with assets that keep their prices within a relatively small range will be less susceptible to volatile losses. For example, in such conditions, stablecoins or wrapped versions of coins operate, which means that in such pools the risk of inconsistent losses for liquidity providers is lower.
So why do providers continue to provide liquidity if they are exposed to potential losses? The fact is that inconsistent losses can be compensated for by trading commissions. Even pools on Uniswap, which are significantly susceptible to volatile losses, allow for profit through trading fees.
Uniswap charges a 0.3% fee on each trade and passes these funds on to liquidity providers. A pool with a large trading volume will be quite profitable for liquidity providers even with a high risk of variable losses. However, this will also depend on the protocol, the specific pool, escrowed assets and market conditions.
How does an impermanent loss occur?
Let's look at an example of what an impermanent loss might look like for a liquidity provider.
Alice contributes 1 ETH and 100 DAI to the liquidity pool. In a given Automated Market Maker (AMM), the monetary amounts in both tokens deposited must be equivalent. That is, at the time of deposit, the price of 1 ETH is equal to 100 DAI, and the total value of Alice’s deposit in dollars is 200 US dollars.
In total, the pool contains 10 ETH and 1000 DAI - these funds are funded by other liquidity providers. So, Alice's share in the pool is 10%, and the total liquidity is 10,000.
Let's say the price of 1 ETH rises to 400 DAI. In this case, arbitrage traders will add DAI to the pool and remove ETH from it until the ratio reflects the current price. Since AMM does not have an order book, prices here are determined by the ratio between the assets in the pool. While the liquidity of the pool remains stable (10,000), the ratio of assets in it changes.
If the current price of ETH is 400 DAI, then arbitrage traders change the ratio in the pool to 5 ETH and 2000 DAI.
So, Alice decides to withdraw her funds. As mentioned earlier, its share is 10%. As a result, she will receive 0.5 ETH and 200 USDT for a total of 400 USD. On the one hand, she made a profit of 200 USD. But what if she had decided not to invest her funds in the pool in the first place? Then the total value of her assets would now be 500 USD.
It turns out that it would be more profitable for Alice to hold (HOLD) assets rather than invest them in the liquidity pool. It is precisely such cases that are called impermanent losses. In our example, Alice's losses were not so large, since the deposit was relatively small. However, remember that an intermittent loss can also result in significant losses (including part of the original deposit).
The above example did not take into account the trading commissions that Alice would receive for providing liquidity. Often, the commissions earned cover losses and make providing liquidity profitable. However, being aware of impermanent losses is critical if you intend to provide liquidity to a DeFi protocol.
Estimation of non-permanent losses
Impermanent losses occur when prices change. But how big can they be? Let's look at the chart below. Please note that it does not take into account liquidity fees.
According to the schedule, the losses compared to retention will be as follows:
1.25x price change = 0.6% loss
1.5x price change = 2% loss
1.75x price change = 3.8% loss
2x price change = 5.7% loss
3x price change = 13.4% loss
4x price change = 20% loss
5x price change = 25.5% loss
It should be noted here that non-permanent losses occur regardless of which direction the price moves. The non-permanent loss depends only on the ratio of the price and the term of the deposit. If you'd like to explore this further, check out Pintail's article.
Risks of providing liquidity to the AMM protocol
The name “impermanent loss” does not describe this effect entirely correctly. The loss is not permanent because it only appears after funds are withdrawn from the liquidity pool. However, at this point the losses become permanent. Commissions earned help offset losses, but the name can still be misleading.
Be careful when depositing funds into the AMM protocol. As we discussed earlier, some liquidity pools are more susceptible to volatile losses than others. This is usually driven by the volatility of the assets in the pool: the higher the volatility of the assets, the more susceptible the pool is to volatile losses. It is wiser to start by depositing a small amount to gauge potential profits before risking a larger deposit.
We recommend choosing proven and reliable AMMs. DeFi gives users the ability to easily fork existing AMMs and make their own changes to them, however, these forks are not bug-proof, which could leave your funds stuck in the AMM forever. If a liquidity pool promises unusually high returns, there are likely trade-offs and high risks involved.
Summary
Impermanent loss is one of the fundamental concepts that anyone who wants to provide liquidity for AMMs should be aware of. Its essence lies in the fact that the liquidity provider may incur losses when the price of deposited assets changes.
