TL;DR

Impermanent loss (IL) occurs when the price of assets in a liquidity pool changes compared to when they were deposited, leading to a lower value than simply holding the assets. It affects liquidity providers (LPs) in DeFi platforms like Uniswap and SushiSwap. The bigger the price movement, the greater the loss. IL is only realized if assets are withdrawn before price recovery. Strategies to mitigate IL include using stablecoin pairs, taking advantage of yield farming incentives, using dynamic pools, and single-sided liquidity provision.

What is impermanent loss?

Impermanent loss occurs when the price of assets inside a liquidity pool changes compared to when they were deposited. The more significant the price divergence, the greater the impermanent loss. The term “impermanent” arises because the loss is only realized if the liquidity provider withdraws their assets from the pool while the price imbalance persists. If the price eventually returns to the initial ratio, the loss disappears.

Impermanent loss is a direct result of how Automated Market Makers (AMMs) like Uniswap, SushiSwap, and Balancer operate. These platforms rely on liquidity pools where users deposit pairs of tokens to facilitate trading. The AMM algorithm adjusts the pool’s token ratios based on supply and demand, which can lead to impermanent loss.

How Does Impermanent Loss Occur?

Liquidity providers supply two assets in equal value to a liquidity pool (e.g., ETH/USDT) on automated market makers (AMMs) like Uniswap, Balancer, or SushiSwap. When traders use the pool, the ratio of these assets changes, impacting LPs in the following way:

• Price Change: If the price of one asset rises or falls significantly, the automated balancing mechanism adjusts the pool’s composition.
• Arbitrage Opportunities: Traders capitalize on price differences between the pool and external markets, buying the underpriced asset and selling the overpriced asset.
• Resulting Loss: When an LP withdraws liquidity after price movement, they may receive fewer valuable assets than if they had simply held them outside the pool.

Example of Impermanent Loss

Suppose Alice deposits 1 ETH and 2,000 USDT into a pool where ETH is initially worth $2,000. The pool maintains a 50/50 ratio, meaning Alice’s deposit is worth $4,000.

• If ETH’s price rises to $3,000, arbitrage traders will rebalance the pool, reducing Alice’s ETH holdings while increasing her USDT holdings.
• Upon withdrawal, Alice might receive 0.8 ETH and 2,400 USDT, totaling $4,800.
• However, if Alice had simply held 1 ETH and 2,000 USDT without providing liquidity, she would have had $5,000.
• The $200 difference is the impermanent loss.

How to Calculate Impermanent Loss

Impermanent loss can be calculated using a mathematical formula that compares the value of assets in a liquidity pool to their value if they were simply held without providing liquidity. 

The formula is:

IL = 2 priceRatio / (1 + priceRatio) – 1

where priceRatio is the new price of the asset divided by its initial price. The larger the price change, the greater the impermanent loss. 

For example, if the price of an asset increases by 50%, the LP will face an impermanent loss of approximately 2%. If the price doubles, the impermanent loss rises to 5.7%. This loss occurs because the automated market maker (AMM) adjusts the token ratio in the pool, resulting in the LP holding a different quantity of assets than they initially deposited. However, transaction fees and liquidity incentives can sometimes offset or even exceed this loss, making liquidity provision profitable despite impermanent loss risks.

How to Mitigate Impermanent Loss

To reduce the impact of impermanent loss, liquidity providers can adopt several strategies. 

• One approach is to choose low-volatility trading pairs, such as stablecoins (e.g., USDC/DAI), which experience minimal price fluctuations. 
• Additionally, selecting pools with high transaction fees can help offset potential losses, as trading fees contribute to overall earnings. 
• Some DeFi platforms, like Bancor, offer impermanent loss protection, ensuring that LPs are compensated for any loss over time. 
• Diversifying liquidity across multiple pools and assets can also help minimize risk, spreading exposure rather than concentrating it in a single volatile pool.

Conclusion

Impermanent loss is a fundamental risk in DeFi liquidity supply. Although LPs have the opportunity to gain transaction fees and rewards, they should consider the possible losses from fluctuations in asset prices. Grasping the mechanics of impermanent loss and applying approaches to reduce its impact is essential for optimizing DeFi returns while managing risk efficiently. 

FAQs

What is impermanent loss in DeFi?

• Impermanent loss refers to the temporary reduction in the value of a liquidity provider’s assets due to price fluctuations in a liquidity pool. The loss becomes permanent if the assets are withdrawn while the price difference remains.

Why is it called “impermanent” loss?

• It is called “impermanent” because if the asset prices return to their original levels, the loss disappears. However, if prices do not revert, the loss becomes permanent upon withdrawal.

Can trading fees compensate for impermanent loss?

• Yes, in high-volume pools with significant trading activity, the fees earned may exceed the impermanent loss, making liquidity provision profitable despite price fluctuations.

Should I still provide liquidity despite impermanent loss?

• It depends on the trading fees, incentive rewards, and the risk of price fluctuations. If the fees and rewards earned are higher than the potential loss, providing liquidity can still be profitable.