Impermanent loss is one of the biggest risks associated with putting your crypto in a liquidity pool.
In this guide, we’ll break down everything you need to know about impermanent loss — including steps you can take to limit your risk!
What is impermanent loss?
Impermanent loss occurs when the price of the crypto-assets in a liquidity pool change relative to each other. This means that the balance of assets within the pool will change in favor of the poorer-performing asset.
How do liquidity pools work?
To better understand how impermanent loss works, let’s walk though the basics of how liquidity functions in both centralized and decentralized exchanges.
Where does liquidity come from in a centralized exchange?
In a traditional exchange, centralized players like Coinbase provide the liquidity needed to execute trades. For example, if you want to trade DAI for ETH on Coinbase, Coinbase will sell you ETH from its own inventory.
Where does liquidity come from in a decentralized exchange?
Decentralized protocols do not rely on centralized market makers like Coinbase. Instead, protocols like Uniswap rely on liquidity pools, where users can contribute their own cryptocurrency that can be used as liquidity in trades.
Most liquidity pools allow users to deposit two or more crypto-assets. In exchange, liquidity providers receive transaction fees from swaps facilitated by the liquidity pools.
For example, let’s say that you own ETH and wBTC. Instead of simply holding your cryptocurrencies, you can place them into a liquidity pool where investors can swap ETH for wBTC and vice versa. In return, you’ll receive transaction fees from these swaps.
How do liquidity pools determine the mix of different assets?
Liquidity pools typically use the following formula to determine the total amount of different assets contained within the pools.
X*Y=K
In this case, X is the total value of the first asset, Y is the total value of the second asset, and K is a constant value.
As a result, the ‘mix’ of assets contained within the liquidity pool can change drastically based on how the price of each asset changes.
Impermanent loss example
Let’s take a look at an example to better understand how impermanent loss works.
Jonathan deposits $500 of Ethereum and $500 of Polygon into a $10,000 liquidity pool. Jonathan is entitled to 10% of the value of the liquidity pool ($1,000/$10,000).
The value of Jonathan’s ETH rises to $1,000, while Polygon’s value stays the same.
The liquidity pool rebalances so that it holds less ETH and more Polygon.
The value of the liquidity pool rises to $13,000.
Jonathan withdraws his holdings for $1,300—$650 worth of ETH and $650 of Polygon.
While Jonathan did make a profit, his assets would have been worth $1,500 had he simply held onto his cryptocurrency ($1,000 of ETH and $500 of Polygon). This $200 difference between his potential and realized profits is what we would call ‘impermanent loss’.
It’s important to remember that this is a simplified example. We did not account for the transaction fees that Jonathan could potentially earn for depositing his cryptocurrency in a liquidity pool.
Can you recover from impermanent loss?
It is possible to recover from impermanent loss if the ratio of the asset values in the liquidity pools returns to previous levels. However, it’s not guaranteed that two uncorrelated assets will return to previous levels after a large change in price.
How does impermanent loss happen?
Impermanent loss happens when there is volatility in crypto prices. When cryptocurrencies change in price relative to each other, the balance of assets in a liquidity pool changes as traders take advantage of the arbitrage opportunity — leading to impermanent loss.
How to calculate impermanent loss
To estimate your impermanent loss, find the current value of your initial deposit. Next, find the current value of your portion of the liquidity pool. The difference between these two values is your impermanent loss.
Here’s a formula you can use for calculating impermanent loss.
Current value of initial deposit - current value of your portion of the staking pool = Impermanent Loss
How risky is impermanent loss?
Impermanent loss is a risk that should be considered any time you deposit your cryptocurrency in a liquidity pool.
However, you should measure the risk of impermanent loss against the potential benefits of receiving transaction fees from a liquidity pool.
In addition, it’s important to remember that the cryptocurrency market is volatile and any exposure can be considered ‘risky’.
How do you avoid impermanent loss?
Unfortunately, there’s no way to completely avoid impermanent loss when using DeFi protocols. However, there are steps you can take to mitigate the possibility.
Impermanent loss is more likely to occur if you deposit volatile token pairs. It’s less likely to occur if you deposit cryptocurrencies that are highly correlated in price with one another — such as two pairs of stablecoins.
Some protocols such as Curve offer liquidity pools of similarly behaving assets to minimize the risk of impermanent loss.
