What is impermanent loss and how to avoid it?

Examples of impermanent loss

Impermanent loss is the potential reduction in returns a liquidity provider experiences when the value of deposited assets in a pool differs from holding them separately due to price changes and arbitrage.

Let’s dive into an example to make impermanent loss crystal clear. 

Imagine you’ve added Ether (ETH) and Dai (DAI) to a liquidity pool. ETH is a popular cryptocurrency, and DAI is a stablecoin pegged to the United States dollar. Say you add 1 ETH (worth $2,000) and 2,000 DAI to the pool. Your total contribution is $4,000.

Now, let’s see what happens when the price of ETH changes. If ETH’s price jumps to $3,000, arbitrage traders will step in. They’ll buy ETH from the pool until the ratio of ETH to DAI reflects the new market price. This activity ensures the pool’s ETH/DAI ratio stays balanced with the market, but it affects your holdings.

After the price change and arbitrage activity, you might end up with around 0.816 ETH and 2,448 DAI. If you withdraw your liquidity at this point, you get assets worth $4,896. However, if you’d just held onto your 1 ETH and 2,000 DAI outside of the pool, you’d have $5,000. 

The difference, $104, is your impermanent loss. 

This example shows how price fluctuations and arbitrage can impact a liquidity provider’s returns. Even if the total value of your assets increases, it might still be less than if you’d held onto them separately.

That’s impermanent loss: potential earnings you miss out on because of your participation in the liquidity pool.

Did you know? During extreme market conditions, some liquidity pools have experienced impermanent losses exceeding 50%. This underscores the importance of carefully selecting asset pairs and strategies to mitigate such risks.

How impermanent loss occurs

Let’s take a look at another example. 

Imagine you deposit 1 ETH and 100 USDt (USDT) into a pool, where 1 ETH is worth 100 USDT (for the sake of simplicity). The pool now has an equal value of both assets.

If the price of ETH increases to 200 USDT, arbitrage traders will jump in to balance the pool. They’ll add more USDT and take out ETH to maintain the price ratio. This means your share of ETH in the pool decreases, and your share of USDT increases.

So, what’s the exact impermanent loss?

Let’s start with the formula itself: 

Let’s break these equations down. 

• Price Ratio (𝑘): 𝑘 is the ratio of the new prices of the two assets after the price change. It is calculated as the new price of asset A (Pnew,𝑎) divided by the new price of asset B (Pnew,𝑏).
• Multiplication and Division: This refers to the second part of the formula that adjusts for the proportional changes in the pool’s asset values. The factor of 2 ensures the formula accurately reflects the compounded effect of the price changes.
• Subtraction from 1: This final step converts the adjusted ratio into a measure of loss. By subtracting the result from 1, the formula quantifies the impermanent loss compared to simply holding the assets.

Applying the formula to calculate impermanent loss

Let’s start by defining the initial conditions and price change: 

• Initial price of ETH: 100 USDT
• Initial price of USDT: 1 USDT (constant)

Assume we deposit 1 ETH and 100 USDT into the pool and ETH doubles in price:

• New price of ETH (Pnew,ETH): 200 USDT
• Price of USDT (Pnew,USDT): 1 USDT (constant)

Let’s now apply the impermanent loss formula to this scenario:

1. Calculate the new price ratio (𝑘):

2. Apply the formula:

3. Calculate the square root of 𝑘: 

4. Plug the values into the formula:

5. Perform the multiplication and division:

6. Convert to a percentage:

In this example, the 14.07% represents the potential loss you experience in value by providing liquidity compared to just holding the assets. 

This loss is “impermanent” because if the price of ETH and USDT returns to their original ratio, this loss will disappear. However, during the period where the prices have diverged, this is the effective loss in value due to the relative price change and the automatic rebalancing of the liquidity pool.

Did you know? The Uniswap protocol, launched in November 2018 by Hayden Adams, played a crucial role in popularizing the concept of automated market making. The impermanent loss formula became widely recognized through Uniswap’s implementation and documentation as liquidity providers began to understand the impact of price divergence on their pooled assets.

Tools and calculators for calculating impermanent loss

CoinGecko offers an easy-to-use impermanent loss calculator. By inputting the initial and current prices of your assets, you can quickly see how much impermanent loss you might experience. This tool is especially useful for beginners who want a straightforward way to assess their risks.

GitHub’s impermanent loss calculator

Another useful tool is GitHub’s impermanent loss calculator. This open-source tool provides a more detailed analysis, allowing you to input various parameters to understand how different factors impact impermanent loss. It’s a great resource for those who want a deeper dive into the calculations.

Using these calculators can help you make more informed decisions when participating in liquidity pools. Valuable insights into potential losses are key to managing your investments and reducing risks.

Managing and mitigating impermanent loss

Impermanent loss is a real concern for liquidity providers, but there are strategies to manage and reduce exposure. 

Here are some practical tips.

• Use stablecoins or low-volatility asset pairs: Pairing stablecoins like DAI or USD Coin (USDC) can significantly reduce impermanent loss since their values remain relatively stable. Low-volatility asset pairs also minimize the risk of large price swings, helping to keep your investment more secure.
• Participate in liquidity pools with higher trading fees: Pools that charge higher trading fees can help offset impermanent loss. The fees collected from trades in the pool can compensate for the potential loss, making your overall returns more favorable. Look for pools that have a high volume of trades and higher fee structures.
• Diversify investments across multiple pools: Spreading your investments across various pools can help mitigate risk. By diversifying, you’re less exposed to the price fluctuations of a single pair. This strategy balances out potential losses in one pool with gains in another, leading to more stable returns.
• Utilize impermanent loss protection features: Some DeFi platforms offer features specifically designed to protect against impermanent loss. These platforms may provide insurance or compensation mechanisms that cover a portion of the loss. Taking advantage of these protections can safeguard your investments and give you peace of mind.

By applying these strategies, you can better manage and reduce your exposure to impermanent loss, making your liquidity provision more profitable and less risky.

Risks and rewards of providing liquidity

Impermanent loss is the most talked-about risk in liquidity provision. Naturally, the greater the price divergence, the more significant the impermanent loss. 

However, it’s not the only risk of providing liquidity. 

DeFi platforms operate on smart contracts, which are not infallible. Bugs, vulnerabilities or exploits in the smart contracts can lead to significant financial losses. Even with audits, the risk of unforeseen issues remains.

Moreover, the regulatory environment for DeFi is still evolving. Changes in regulations can impact the functioning of DeFi platforms and the legality of certain activities, potentially leading to asset freezes or other legal complications.

Also, in times of extreme market stress, liquidity can dry up, making it difficult to withdraw your funds quickly without significant slippage. This can trap investors in positions that are rapidly losing value.

So, what makes it worthwhile? 

Trading fees, mainly. Liquidity providers earn a portion of the trading fees generated by the pool. High-volume pools can generate substantial fee income, providing a steady and potentially lucrative revenue stream.

Many DeFi platforms also offer incentives in the form of native platform tokens. These rewards can significantly boost the overall return on investment, especially if the token appreciates in value.

Did you know? In high-volume liquidity pools, it’s not uncommon for liquidity providers to earn annual percentage yields (APYs) of over 20% or even higher, depending on the platform and the specific pool; however, these rewards need to be weighed against the potential risks, such as impermanent loss and smart contract vulnerabilities.

Governance tokens are also frequently issued to liquidity providers, giving them a voice in protocol decisions. This participation can be rewarding as it allows you to influence the direction of the platform and potentially benefit from its growth.

Moreover, by participating in liquidity pools, you may also gain access to yield farming opportunities. Yield farming can provide additional returns through incentives provided by DeFi protocols to attract liquidity.

For these reasons and more, many find that the risk of impermanent loss is worth the reward, much like those who sow their seeds in flood-prone fields.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.