Liquidity significantly impacts asset prices, so it’s essential in both traditional markets and DeFi. Anyone, who has staked their assets in DeFi knows the immediate risks of a liquidity pool, one of them being impermanent loss.
As we unfold the meaning & working of Impermanent Loss, we will also discuss why is it essentially happening & ways in which investors can minimize or prevent this risk.
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Impermanent Loss is the temporary loss of funds when an investor provides liquidity to a pool and the relative price of the deposited asset changes in comparison to their initial value during the deposit.
Think of it as the opportunity cost of the funds you lose whenever you invest funds in a liquidity pool.
You can do two things with your crypto — earn yield on it or HODL.
HODL is a crypto slang for Hold On to Dear Life. It’s the same as a buy-and-hold investment strategy.
Before we move forward, here are some points to keep in mind about a liquidity pool :
- Number of tokens A x Number of tokens B = k (constant)
- No. of token A x Price of token A = No. of token B x Price
( If you are unfamiliar with the above concepts, refer to ‘Liquidity Pools’ for a simplified explanation. )
Impermanent loss can happen in the following scenarios. Let’s understand these cases with examples.
- One of the token’s price rises drastically
- One of the token’s price falls drastically
- The price of both tokens move in the opposite direction
Let’s say we invested $10,000 in a DAI/ETH liquidity pool. As the initial deposit is supposed to be in a 50:50 ratio, we provided liquidity of 2.5 ETH & 5000 DAI.
Case 1: The price of ETH rises 50%
When we invested in the liquidity pool & the price of ETH rises 50%, our initial deposit of $10,000 is now worth $12, 247.44 . Congrats!! we made a profit of $2247.44 or 22.47%.
But wait, if we had just held onto our tokens they would be now worth $12,500, making us a profit of $2500 or 25%.
Though we made a good profit by putting our money in the liquidity pool, we incurred a $253 loss of potential profits.
So, our impermanent loss is 2.02%.
Case 2: The price of ETH falls 50%
Let’s take another example. This time instead of a 50% increase, the ETH price fell 50%. Our total pool value went from $10,000 to $7071.06, incurring a loss of $2,928.94 or -29.3%.
But if we had just held on to our tokens, they would now be worth $7,500. This would result in a loss of $2500 or -25%.
So this time our impermanent loss is -5.72%.
The above chart explains how much impermanent loss a liquidity provider may experience in terms of how much that asset changes in price.
It is essential to know that impermanent loss can take place irrespective of the price direction.
The bigger this difference is, the more an investor is exposed to the loss. It is essential to know that impermanent loss can take place irrespective of the price direction.
Or to put it another way:
a 1.25x price change results in a 0.6% loss relative to HODL
a 1.50x price change results in a 2.0% loss relative to HODL
a 1.75x price change results in a 3.8% loss relative to HODL
a 2x price change results in a 5.7% loss relative to HODL
a 3x price change results in a 13.4% loss relative to HODL
a 4x price change results in a 20.0% loss relative to HODL
a 5x price change results in a 25.5% loss relative to HODL
Note, that the loss is the same in whichever direction the price change occurs. Doubling in price results in the same loss as a halving. ETH with an initial price of $2000 — its impermanent loss would be the same, -5.72% whether the price doubles to $4000 or halves to $1000.
In both of our previous cases, only the price of ETH was moving. It becomes trickier when both of our tokens start moving. This time, we’ll change our pool. Let’s assume we have a new token called Kitty tokens or KTY.
And we will provide liquidity in KTY/ETH pool.
Our initial deposit was $10,000. We provided 5000 KTY & 2.5 ETH to the pool.
When the price of KTY increases by 50% & ETH falls by 50%, our total pool value went from $10,000 to $8,660.25 .
Investing in a liquidity pool, incurred us a loss of $1339.75 or -13.4%.
If we had just held on to our tokens, they would still be worth $10,000 ( i.e. 5000 KTY tokens worth $1.5 & 2.5 ETH worth $1000 ) & we wouldn’t have incurred any loss.
This makes our impermanent loss to be $1339.75 or -13.40%.
As you can see, the impermanent loss is more when the prices of both tokens move in the opposite direction compared to when only one token moves. This is because the more the prices deviate from those at which you made your initial deposit, the higher your permanent loss will be.
This is why liquidity pools with non-volatile tokens (like a stablecoin) are preferred to minimize or prevent impermanent loss.
With our initial deposit of 5000 KTY worth $1 each & 2.5 ETH worth $2000 each, what would you think would happen when both prices fall equally?
TASK: Both the tokens fell 50%. Now one KTY token is worth $0.5 & one ETH is worth $1000. Calculate the impermanent loss.
Use this Impermanent Loss Calculator & observe the loss percentage.
Note: You can play around with this calculator, try different price ratios & see its effects. This will help you understand these concepts better. Don’t be disheartened if you find it hard to wrap your mind around the concept of Impermanent Loss. It is a complex topic, especially for beginners. Use this calculator, and read the above examples again & you would eventually get it.
Coming back to scenario 3, though both of our tokens fell 50%, our impermanent loss was zero.
This is because though the prices fell, the difference between the two assets was not changed, their ratio was still intact. This cancels the impermanent loss.
The ratio between the assets in the pool determines their price. It is the only significant factor that can decide the intensity of the relation between tokens.
1. Provide to Stablecoin Pair
As we saw in the above examples, having one stablecoin (DAI) in our token pair minimized our impermanent loss. When both the tokens are stablecoin, we wouldn’t have to worry about impermanent loss. This is the safest option.
But, because stablecoin pools are the most preferred ones, they are also crowded resulting in low returns.
2. Avoid Volatile Coins
New & low liquidity tokens are quite volatile. Though they might promise high rewards, the impermanent loss would also be high.
3. Additional Incentives
Some new protocols offer attractive incentives to lure investors to their pools . These incentives can include high liquidity provider fees & liquidity mining fees which can compensate our impermanent loss.
4. Provide to Pools with Customizable Ratio
The liquidity pool ratio is usually 50:50. But some innovative platforms allow customization of the ratio, like an 80:20 or 90:10 ratio.
Then some pools have more than 2 assets, these can be used to minimize risks.
Balancer & Bancor are two DeFi protocols you should check out.
5. Wait for it to return to its initial ratio
The more the prices deviate from those at which you made your deposit, the higher your permanent loss will be. Therefore, just waiting for the crypto prices to return to their initial rates, and not withdrawing your currency until then is also a good measure, but it’s hard as the crypto market is quite volatile.
Remember, it is only an impermanent loss. If our invested funds are withdrawn before the tokens return to their original price levels, only then will our impermanent loss be realized & become a permanent loss.
So, why do liquidity providers still provide liquidity if they’re exposed to potential losses?
The returns from trading fees, liquidity mining & yield farming can compensate for our impermanent loss & even give good profits. We’ll explore Liquidity Mining & Yield Farming in future articles.
I hope this was helpful & you learned something new.
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