What is impermanent loss?
Impermanent loss refers to a temporary loss of value when providing liquidity to a decentralized finance (DeFi) protocol.
Liquidity pools are fundamental to the functioning of automated market maker platforms (AMMs), which allow users to trade between assets without needing a traditional central order book. Using liquidity pools, traders are able to swap between two different cryptocurrencies, thereby altering the balance of each asset held in the pool.
When a liquidity provider (LP) deposits a ratio of tokens into a pool, they are essentially making assets available for other protocol users to trade against.
Contributing tokens to a liquidity pool first involves locking them into a smart contract. LPs cannot use their locked assets for other trading purposes while they're committed to the liquidity pool.
However, due to volatile asset prices and the AMM mechanism, the value of assets locked in a liquidity pool can sometimes decrease compared to if the liquidity provider simply held the assets and did not provide liquidity.
This price discrepancy is called impermanent loss.
How does impermanent loss occur?
Impermanent loss occurs because of three factors:
- Crypto market volatility
- AMM pricing algorithms
- LP token redemption
During periods of high volatility, the market prices of assets deposited in a liquidity pool can change.
The change might arise from several factors, such as a project reaching a certain roadmap milestone, launching new partnerships, and other factors that affect the future outlook of the protocol.
Price volatility can also be caused by negative outcomes that cause the price of the asset to decrease. Crypto markets can be volatile and sentiment about an asset changes rapidly. In turn, these price changes can contribute to impermanent loss.
AMM pricing algorithms
Most AMM pricing algorithms maintain a fixed 50/50 ratio of assets in the pool, such that the USD value of both assets must equal the same value.
As an example, an ETH/DAI pool with a total value locked (TVL) of $100,000 would contain $50,000 worth of ETH and $50,000 worth of DAI at its current US dollar value.
To maintain this ratio in accordance with the market, the AMM pricing algorithm automatically adjusts the prices of the paired assets within the pool.
During periods of high volatility, this can sometimes mean prices of assets held in a liquidity pool are cheaper or more expensive than their present market value.
When this happens, the discrepancy attracts arbitrage traders who aim to earn a profit by removing the discounted assets from the liquidity pools and adding the other paired asset to the pool.
Arbitrage traders continuously participate in this process in order to earn a profit from keeping the value of paired assets in the pool aligned with current market prices.
LP token redemption
When a liquidity provider wishes to withdraw their paired assets from the pool, they must burn their LP tokens.
LP tokens represent a LP’s percentage share of the assets in the pool. They do not represent the exact amount of assets the LP originally deposited.
This factor means that LPs are not guaranteed to receive the exact same amount of assets they deposited. Instead, the amount they recieve back depends on the total value of the liquidity pool, the prices of the assets held within that pool, and what their individual percentage share of the full pool equals.
The complex nature of how impermanent loss can occur makes participating in liquidity pools an important decision for any crypto trader.
Those first entering the crypto space should first understand the nuances and risks of decentralized finance before depositing funds in liquidity pools.
Minimizing impermanent loss
While impermanent loss is an inherent risk associated with providing liquidity, several strategies can help traders and liquidity providers mitigate its impact:
- Pair selection: Choosing digital asset pairs with less price volatility can reduce the risk of impermanent loss. Highly volatile pairs are more likely to experience significant price divergences, and therefore pose more of a risk of incurring impermanent loss.
- Stablecoins: Liquidity providers can opt for stablecoin pairs, where one of the tokens is a stablecoin with a relatively stable value. This strategy reduces the risk of impermanent loss as stablecoins tend to have less price fluctuation.
- Hedging: Some liquidity providers hedge their positions by simultaneously trading the tokens they provide liquidity for on other platforms. This strategy often helps to offset potential losses due to price divergence. You can check out our Kraken Learn Center article What is Hedging? to learn more.
- Yield farming and incentives: Some platforms offer additional rewards beyond trading fees, such as governance tokens, in return for providing liquidity. These added incentives provided by the protocol can help to offset the potential risks of impermanent losses.
- Regular monitoring and adjustment: Regularly checking the status of the liquidity pool can help minimize the impact of impermanent loss. Several automated tools and services can help with this process.
- Diversification: Rather than providing liquidity to a single pool, diversifying across multiple pools and types of cryptocurrency can help spread the risk of impermanent loss.
- Long-term perspective: If liquidity providers are willing to hold their digital assets for an extended period, impermanent losses might eventually be offset by trading fees and potential appreciation in the tokens' values.
Impermanent loss is a concept that all liquidity providers in the DeFi space should consider.
With a clear understanding of how impermanent loss occurs, as well as a careful risk management approach, traders and liquidity providers can work to minimize the effects of impermanent loss as they dive deeper into the evolving world of decentralized finance.
Impermanent loss example
An example of impermanent loss might look like this.
A DeFi user wishes to provide liquidity to an ETH/USDC pool. In order to provide liquidity, the must deposit equal values of both assets in the liquidity pool, given their current market price
In this example, let’s say the liquidity provider deposits 2 ETH and 3,000 USDC into the ETH/USDC liquidity pool.
Let’s also say that the liquidity pool holds 40 ETH and 60,000 USDC in total, meaning the user's deposited assets equals 5% of the total value of the pool.
Over time, ETH price may change in value compared to USDC. For this example, let’s say the market price of ETH has doubled in value, and is now worth 3,000 USDC.
There is now a sizable discrepancy between the market price of ETH and the price of ETH in the liquidity pool.
Some traders recognize the arbitrage opportunity and begin adding USDC to the pool to remove the discounted ETH coins. Eventually, the pool rebalances, making the total value of the remaining ETH in the pool equal the same as its value in USDC.
However, after arbitrageurs rebalance the pool, it now contains 28.28 ETH and 84,852.81 USDC. The 28.28 ETH at its new price of $3,000 equals $84,852.81, which is the same value as the number of USDC tokens in the pool.
Anyone can calculate their potential liquidity mining risk using online impermanent loss calculators.
If the liquidity provider decided to withdraw their share of the pool, they would realize a loss of 5.72% compared to if they had simply held their crypto assets and not provided liquidity to the pool.
However, they would also earn a portion of the fees that trading within the pool generated. Depending on how much they earned for providing liquidity, these fees may or may not offset the impact caused by impermanent loss.
It's important to note that impermanent loss is "impermanent" because it only becomes realized if the user withdraws their liquidity when the prices have moved unfavorably. If the user waits, and the prices revert or balance out, the impermanent loss may decrease or disappear.
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