If you’re an AMM user seeking to understand the concept of impermanent loss, you’ve come to the right place.You’ll learn about impermanent loss and understand how it can affect your liquidity pool. You’ll also get tips on how to minimize your risk of impermanent loss.

What are liquidity pools?

DEXs, or decentralized exchanges, use what are called Automated Market Makers (AMMs). This enables the trader to passively earn exchange fees for allowing retail investors to pool their assets together to provide the DEX with liquidity. In exchange for providing liquidity in the pool, these “liquidity providers” (LP) receive LP tokens, which represent the value of their assets they have in the pool.

Liquidity providers stake their crypto assets in liquidity pools to earn passive income through other people’s trading fees.

How does impermanent loss occur?

Liquidity pools can be a great way to earn passive income, but it’s important to understand that crypto assets can change value while in the liquidity pool, even if the value of the crypto increases. Impermanent loss refers to when the value of the tokens inside of a liquidity pool diverges from the value of the same tokens outside of the pool. The more significant the price change is, the greater the impermanent loss becomes.

But if my crypto loses value, how is it impermanent? 

Impermanent loss only becomes permanent when you withdraw your crypto assets from the liquidity pool, similar to how you only lose value on a spot trade if you sell at a loss, also known as realized loss. If your tokens return to their original value, then you are no longer at a loss.

Why does impermanent loss occur in the first place?

In the world of online brokerages and exchanges, we’re used to the luxury of instant and automatic price changes. Unfortunately, AMMs are new and DEXs don’t operate in the same way as traditional exchanges. On DEXs, the price of an asset changes slowly with the help of arbitrageurs, who discover price differences in these markets and take advantage of arbitrage opportunities by buying an underpriced asset or selling an overpriced asset.

Arbitrage is the simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset. 

This cycle repeats until the price of the asset in the AMM mirrors its price in external markets.

 

Example

To explain impermanent loss more clearly, let’s look at an example using FLEX and USDC.

Let’s say 1 FLEX is the equivalent of 0.20 USDC.

If you have a total of $200 in the pool, to create an equal amount of crypto on both sides of the scale, the crypto would need to be split with 100 USDC valued at $100 USD and 500 FLEX valued at $100 USD.

To understand how the LP would benefit by staking crypto into this pool, let’s now say the total liquidity of the pool is split 50:50 with 50,000 FLEX and 10,000 USDC. You own 1% of the pool (and your LP token is, therefore, worth 1% of the pool and as a result will receive 1% of the trading fees).

In this example, let’s say the price of FLEX increases to 0.40 USDC. The price of FLEX in the pool will not react automatically. Instead it will react manually, via the help of arbitrageurs who buy up the FLEX at the discounted rate until its value rises up to 0.40 USDC and matches the rest of the market. USDC will be injected into the pool, and FLEX will be extracted, balancing the scale. We can see that the ratio between assets determines the asset prices.

Although this is advantageous to arbitrageurs, it comes at a cost to the liquidity provider. As a LP in the pool, you are selling your FLEX even as it continues to appreciate in value. Your 500 FLEX has now decreased to 353 FLEX, and your 100 USDC has become 141 USDC.

If you withdraw your liquidity from the pool, it would leave you with 353 FLEX ($141) + 141 USDC ($141) = $282

Recall that if you had held your assets in a wallet, this would have been 500 FLEX ($200) + 100 USDC ($100) = $300 (assuming the prices mentioned above)

This leaves you with an impermanent loss of $18, making it permanent if withdrawn from the liquidity pool.

Note, however, that if the market for FLEX had fluctuated a lot before reaching 0.40 USDC, you may have collected more than $18 in trading fees, leaving you at a net profit.

 

Are there ways we can stop impermanent loss from happening?

Although we can’t entirely avoid impermanent loss, there are ways to reduce your impermanent loss while trading.

Here are two possible strategies: 

1) Provide liquidity to tokens that will remain within a similar price range

One example is USDC and USD, which is unlikely to range outside a narrow price range such as $0.99-$1.01. This would be a great opportunity to concentrate liquidity, which would make capital more efficient and minimize the risk of impermanent loss.

 

2) Enter a liquidity pool with two tokens that perform similarly and occupy a similar ratio 

These would be tokens that grow proportionally and hold a 50:50 ratio.

 

TL;DR

Impermanent loss occurs when the value of the tokens inside of a liquidity pool diverges from the value of the same tokens outside of the pool, and this can have a significant impact on the liquidity of your pool. There are several ways to reduce the risk of impermanent loss, such as providing liquidity to stablecoins or coins that grow in the same ratio.

 

This article is for educational purposes only and is not financial advice. Please ensure you do your own research before entering a liquidity pool.