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Know Everything about Impermanent Loss

Impermanent Loss often occurs when you have two independent assets artificially bound together in a defined ratio. When you provide liquidity in a liquidity pool , the two assets are algorithmically bound together by the system to ensure that both sides of your pool share will have the same dollar value. Likely, the price of your deposited assets will fluctuate to some degree compared to when you deposited them, so the system balances the pool to recover the ratio of 50% on each side again. The bigger the difference of divergence between the two assets, the more you are exposed to impermanent loss. Impermanent loss happens when you provide liquidity to a liquidity pool, and the price of your deposited assets changes compared to when you deposited them. The bigger this change is, the more you are exposed to impermanent loss.

This is because the deposit can only be protected when it has been confirmed and added to the pool. This also applies for pending liquidity pools that have not been granted as an active pool, as your assets are in a pending pool that is “inactive”. AMMs rely on arbitrageurs to maintain the consistency of prices between assets with respect to their market values.

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IL, in short, is when one of your assets appreciates or depreciates relative to the other asset, it opens up an arbitrary opportunity for others to profit from because they are incentivised to equal the pools. Lastly, it is important to understand that IL occurs no matter which direction the price changes. The only thing IL is concerned with is the price divergence relative to the time of deposit.

What is Impermanent Loss (IL)

Though this is usually not sufficient incentive for people to accept the IL risk. This is the reason why various projects offer additional incentives for token holders to provide liquidity. Phantasma Pharming is such an incentivization protocol, which boosts the APY and significantly offsets the IL risk up to a large total pool size. As discussed previously, there is a huge number of crypto projects today that involve depositing pairs of tokens into liquidity pools. In fact, a large proportion of Decentralized Finance activity revolves around liquidity pools at one level or another. Most ‘staking’ or ‘farming’ activity that you hear about is actually a secondary level of earnings or depositing of tokens on top of an initial pool deposit.

What is Impermanent Loss in DeFi?

If you wanted extra risk mitigation, which would be easier to manage if asset prices didn’t move much. As Bob became more confident in his future price prediction, he was able to make a relative profit by exiting his LP and shifting to simple holding. So by being in an LP position, Alice’s loss was 44.58 BUSD, 0.62% worse off than if she had just held the assets. Impermanent loss definition alongside showcasing examples of how it works and ways for calculating IL. Let’s also say that the price of ETH doubles within a couple of weeks after you begin providing liquidity.

What is Impermanent Loss (IL)

In the liquidity pools, pegged currency pairs have little or no change in value. As In same-pegged asset liquidity pools(e.g. a USDC/DAI pool)there’s very little volatility between the tokens pairs. This dynamic naturally results in little to no impermanent loss for LPs. Therefore if you’re wanting to earn fees as an LP but you’re not down with facing lots of IL, same-pegged liquidity pools may be a good option. Impermanent loss is one of the most intimate experiences liquidity providers ever have with their money.

Liquidity Pools and Significance of AMMs

A liquidity pool must contain a 50/50 ratio in the value of both tokens. If an ETH is worth 100 DAI and there are 10 ETH in the pool, there must be 1000 DAI. Also, note that the token prices in this pool are only affected by the ratio between them and not the prices on external markets. It’s called impermanent loss because the losses only become realized once you withdraw your coins from the liquidity pool. The fees you earn may be able to compensate for those losses, but it’s still a slightly misleading name. Wrapped versions of a coin, for example, will stay in a relatively contained price range.

Like its predecessor, Bancor V3 will fully protect users from a risk that threatens to undermine the core tenets of DeFi. Remember that the value of ETH and DAI must be equal at all times, so 0.3 ETH translates to 0.15 ETH and 15 DAI. If you missed it, here’s the previous piece explaining how numbers get bent through price impact. It’s a subtle phenomenon that can be hard to see in your day-to-day trading, but can mean the difference between profits and losses. This algorithm of operation allows the market to function autonomously, creates an opportunity for arbitrage, but also causes Impermanent Loss in DeFi.

What is Impermanent Loss (IL)

Impermanent Loss happens when you deposit tokens into a liquidity pair and one of the tokens changes in value while the other remains more stable. This is because the liquidity pool maintains a balance in the value of the tokens deposited. When one token increases in value, the amount of that token in the pool decreases, and the other increases to maintain balance. In this case, it would have just been better for you to hold the original tokens to take profits from the run-up. The changes in your balances that occur as a result of the net buy/sell pressure is what’s referred to as impermanent loss – which is a misleading term, but good enough.

How to Avoid Impermanent Loss?

Liquidity providers are susceptible to another layer of risk known as IL because they are entitled to a share of the pool rather than a definite quantity of tokens. As a result, it occurs when the value of your deposited assets changes from when you deposited them.” The AMM does not actually set the price of the assets in the pool; users do this by depositing and withdrawing assets as the price changes. If the TEMPLE price goes higher, more TEMPLE will be taken out by users seeking profits, and more FRAX will be added to the pool. The liquidity stays the same but the ratio of assets in the pool changes. When someone is trading on AMMs like Uniswap and PancakeSwap, they are buying and selling tokens against the liquidity that you and others have provided.

The key reason for the occurrence of an Impermanent Loss can be called the discrepancy between the value of coins in the liquidity pool of the real market situation. At the very least, these rewards can offset IL so as an LP, always keep incentivized liquidity pools in mind. You provide LUSD stablecoin to the Stable Liquidity Pool to ensure Liquity’s solvency and in return you receive the profit accrued from fee.

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Most would argue that the earnings would eventually cancel out the price changes. If ETH is now 400 DAI, the ratio between how much ETH and how much DAI is in the pool has changed. There is now 5 ETH and 2,000 DAI in the pool, thanks to the work of arbitrage traders. While liquidity remains constant in the pool , the ratio of the assets in it changes. The DeFi space is now at its peak and anyone can fork an existing project, adding only minor changes to it. This can cause errors in the operation of the protocol and lead not to temporary, but to quite real losses.

What is Impermanent Loss (IL)

ConsenSys Launches MetaMask StakingMetaMask Portfolio Dapp now supports staking through liquid staking providers Lido and Rocket Pool. ConsenSys Launches MetaMask Learn — The Next Step in Democratizing Web3MetaMask has launched a learning simulation what is liquidity mining platform to help users orient themselves in the world of web3 and self-custodial wallets. MetaMask Learn combines visual learning with action-oriented testing to provide a compelling and engaging way to understand complex web3 concepts.

Risk of Offering Liquidity

Using automated exchanges, investors can deposit their coins into liquidity pools and in return receive rewards , which are calculated in proportion to the shares of the investment. Usually, LPs are also awarded project tokens, which give them the right to vote on decisions to make key changes to the protocol and act as a kind of project shares. An Impermanent Loss occurs when you provide liquidity to a pool and the price of your locked coin changes relative to another one since it was deposited. The larger this change, the more you are exposed to Impermanent Losses.

  • Liquidity is provided by liquidity providers , who usually contribute equal amounts of two assets to the pool.
  • Liquidity providers could receive LP tokens for redeeming the 10% of share in the pool at any time.
  • In fact, even pools on Uniswap that are quite exposed to impermanent loss can be profitable thanks to the trading fees.
  • This loss is only tangible if investors withdraw their liquidity from the pool at that exact moment in time.

In reality, this is true even for professional traders, of whom many are correct on market direction only 55% of the time. Traders may be thinking to themselves that this looks familiar, and that’s for a good reason. This is similar to a strategy often used by traders called dollar cost averaging. You may have seen a chart like the one below that shows the effect of Impermanent Loss as price moves away from your entry.

In this case, the loss means less dollar value at the time of withdrawal than at the time of deposit. By far the most popular use case for liquidity pools is on decentralised exchanges , which have become the backbone of the DeFi ecosystem. Decentralised exchanges allow users to swap cryptocurrency assets via smart contracts. They are able to achieve this through the application of anautomated market maker . Impermanent loss is a unique risk involved with providing liquidityto dual-asset pools in DeFi protocols.

The ratio of the token pair in the pool was corrected for the new ETH price of $5000 by pumping in more stablecoins and removing almost 0.3 ETH. If the impermanent loss is greater than the revenue you have earned from providing liquidity then you will be subsidised the difference. Impermanent loss happens when the price of your token changes after you deposit it in the liquidity pool. Unfortunately, volatility is a part of life in the crypto realm, and prices change often. This profit arises essentially as a portion of the gains the liquidity provider would make by simply holding the two assets, rather than depositing them into a pool.

Interestingly, liquidity pools serve a crucial role in enabling the facility of lending and trading services in DeFi markets. Impermanent loss refers to the fact that you can know about it only after withdrawing your funds from a liquidity pool. Prior to withdrawal, any type of loss estimated on the assets in a liquidity pool would only remain on paper. In the long run, the losses could disappear entirely or reduce by a considerable margin according to market movement. If you have been following the domain of DeFi closely, then you must have witnessed a prominent growth in popularity of DeFi protocols.

Impermanent Loss, Crypto’s Silent Killer, Threatens the Core Tenets of DeFi: Bancor

AMM. As we’ve discussed, some liquidity pools are much more exposed to impermanent loss than others. As a simple rule, the more volatile the assets are in the pool, the more likely it is that you can be exposed to impermanent loss. That way, you can get a rough estimation of what returns you can expect before committing a more significant amount. As we know from earlier, she’s entitled to a 10% share of the pool. As a result, she can withdraw 0.5 ETH and 200 DAI, totaling 400 USD. She made some nice profits since her deposit of tokens worth 200 USD, right?

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