Impermanent loss is a term used in decentralized finance (DeFi) that refers to the potential loss of value experienced by liquidity providers in automated market maker (AMM) protocols like decentralized exchanges (DEXs).
When liquidity providers deposit their assets into a pool, they contribute an equal value of two tokens. However, if the prices of these tokens change, the pool becomes imbalanced, resulting in losses for liquidity providers. Read More
This loss is called “impermanent” because it can be temporary if prices revert to their initial ratio. However, if prices continue to diverge, the loss can become more significant and persist for a longer time. It’s important to note that impermanent loss only affects liquidity providers and not traders. Traders can benefit from the liquidity provided by others.
How does impermanent loss work?
Let’s consider a liquidity pool with two assets, Asset A and Asset B, where you provide liquidity in a 50:50 ratio. You contribute $1,000 worth of Asset A and $1,000 worth of Asset B, totaling $2,000 in liquidity.
Initially, the price of Asset A is $10 per unit, and the price of Asset B is $5 per unit. So, you provide 100 units of Asset A and 200 units of Asset B to the pool.
Now, let’s assume that over time, the price of Asset A increases to $15 per unit, while the price of Asset B decreases to $4 per unit. As a result, the pool becomes imbalanced.
The value of Asset A in the pool increases to $1,500 ($15 * 100), while the value of Asset B decreases to $800 ($4 * 200). The total value of the pool becomes $2,300 ($1,500 + $800), representing a 15% increase.
When you decide to withdraw your liquidity, you receive approximately $1,150 worth of Asset A (50% of the pool’s value) and $1,150 worth of Asset B (50% of the pool’s value).
Now, let’s compare this with a hypothetical scenario where you held the assets separately without giving it to the liquidity pool. If you had held your $1,000 worth of Asset A and $1,000 worth of Asset B separately, their combined value would have been $2,500 ($1,500 + $1,000).
However, by providing liquidity to the pool, you ended up with approximately $1,150 + $1,150 = $2,300, which is less than the hypothetical value of $2,500.
In this example, the impermanent loss is $200 ($2,500 – $2,300), which represents the difference between the value you could have had by holding the assets separately and the value you received after withdrawing from the pool.
Impermanent loss occurs when the relative prices of the assets in the pool change, causing a divergence in the value of your provided liquidity compared to holding the assets separately.
Strategies to avoid impermanent loss
Impermanent loss is an inherent characteristic of providing liquidity in decentralized exchanges, and it cannot be entirely eliminated. These strategies can help to reduce the potential impact
- Provide liquidity for assets with low price volatility: Impermanent loss is more likely to occur when the prices of assets in a liquidity pool experience significant fluctuations. Choosing assets with lower volatility can reduce the potential for loss.
- Consider stablecoin pairs: Stablecoins like USDT, USDC, or DAI aim to maintain a stable value against a reference currency, such as the US dollar. By providing liquidity to stablecoin pairs, where both assets have relatively stable prices, you can minimize the impact of impermanent loss.
- Focus on correlated assets: Select assets that have a high correlation, meaning they tend to move in a similar direction. When their prices are positively correlated, the risk of impermanent loss decreases because their relative values remain more stable.
- Monitor fees earned: Some liquidity pools offer fees to liquidity providers based on the trading activity in the pool. These fees can help offset potential impermanent losses. Considering pools with higher trading volumes and attractive fee structures can mitigate the impact of impermanent loss.
- Time your liquidity provision: Timing the entry into a liquidity pool can be crucial. If there’s a sudden price change in one of the assets, it might be better to wait until the prices stabilize before providing liquidity to minimize the risk of impermanent loss.
Is it possible to recover from impermanent loss and why should we not worry much about it?
Recovery from impermanent loss can occur through two main factors. Firstly, if the prices of the assets in a liquidity pool revert back to their original ratio or stabilize, the loss can be mitigated or reversed. Price movements in favor of the liquidity provider contribute to recovery.
Secondly, liquidity providers earn fees from trading activities in the pool. These fees accumulate over time and can exceed the initial impermanent loss, helping to recover the losses. Higher trading volumes and increased pool activity can speed up this recovery process.
To maximize the chances of recovery, a hold-and-wait strategy can be adopted. Instead of withdrawing liquidity immediately after experiencing impermanent loss, holding onto the liquidity provision and waiting for favorable market conditions allows time for potential recovery.
By considering these factors and allowing time for market dynamics to play out, liquidity providers have the opportunity to recover from impermanent loss.
Is impermanent loss worth it?
The worth of impermanent loss depends on several factors, including potential gains, fee generation, a long-term perspective, and risk tolerance. Impermanent loss represents a temporary loss that liquidity providers may experience due to price fluctuations in a liquidity pool.
One aspect to consider is the potential for gains. If the prices of the assets in the pool appreciate significantly, liquidity providers can benefit from potential profits, which can outweigh the impact of impermanent loss.
Additionally, liquidity providers earn fees from trading activities in the pool. These fees can offset or even exceed the impermanent loss, making it more worthwhile to provide liquidity.
A long-term investment perspective can also influence the worth of impermanent loss. If you are willing to hold your liquidity provision and wait for the prices to stabilize or revert back to their original ratio, the temporary loss may be considered acceptable in the broader context of long-term gains.
Lastly, individual risk tolerance plays a crucial role. It’s essential to assess your comfort level with risk and evaluate whether the potential rewards outweigh the potential losses associated with impermanent loss.
Ultimately, the worth of impermanent loss is a subjective decision that depends on your specific circumstances, investment goals, and risk appetite.
Do you lose tokens in impermanent loss?
No, you do not lose tokens in impermanent loss. Impermanent loss is a concept that applies to liquidity provision in decentralized exchanges, where you provide tokens to a liquidity pool. It refers to the temporary loss in the value of your provided liquidity due to price fluctuations of the assets in the pool.
In impermanent loss, the value of one asset may increase while the other decreases, leading to an imbalance in the pool. When you decide to withdraw your liquidity, you receive a proportionate share of the remaining assets in the pool based on their current values. This means you may end up with fewer tokens of one asset compared to what you initially provided, but you do not lose the tokens themselves.
The loss is considered “impermanent” because it can be mitigated or even reversed over time if the prices of the assets revert back to their original ratio or stabilize. It’s important to note that impermanent loss is a temporary phenomenon and does not involve permanent loss of tokens.
