What is impermanent loss and how to avoid it?

Definition of impermanent loss

As someone who has dipped my toes into the ever-evolving world of DeFi, I can confidently say that liquidity provision is a rollercoaster ride filled with both thrills and chills. The tantalizing allure of potentially high returns has drawn me in like a moth to a flame, but the specter of impermanent loss looms large, casting an ominous shadow over my investments.

Loss due to impermanence occurs when the value of the assets within a liquidity pool fluctuates in relation to one another, leading to a short-term decrease in worth compared to just holding the assets individually.

In the realm of Decentralized Finance (DeFi), offering liquidity could be an uncommon yet possibly rewarding move. But do remember, it’s not without challenges – one major concern being the risk of impermanent loss.

Picture it like sowing seeds in a flood-prone field—the crops you nurture now might be carried off by an unforeseen stream, resulting in fewer returns than your initial investment.

Through learning more about temporary setbacks (impermanent loss) – its calculation methods and top strategies for offering liquidity, you’ll be better equipped to handle the related risks effectively.

In simpler terms, impermanent loss occurs when you supply tokens to a liquidity pool, causing a difference in the price of the assets you’ve deposited compared to their original prices. If the market conditions change, this discrepancy could lead to a temporary decrease in the value of your funds compared to just holding those same assets in your wallet.

Calling it “impermanent” is because the loss isn’t always long-term. If the token prices revert to their initial values, the loss can be mitigated or even eliminated. It’s a risk associated with the opportunity to earn fees from the liquidity pool, where potential rewards may outweigh the temporary setbacks.

Examples of impermanent loss

As a liquidity provider, I face the risk of impermanent loss – this is when the value of the assets I’ve deposited in a pool fluctuates more than if I had held those same assets individually, primarily due to market price changes and arbitrage activities.

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

Picture this: You’ve contributed both Ether (ETH) and Dai (DAI) to a shared liquid reserve. ETH is a widely recognized digital currency, while DAI is a type of coin that maintains its value relative to the U.S. dollar. If you put in 1 ETH, worth approximately $2,000, along with 2,000 DAI, your overall contribution amounts to around $4,000.

Here’s a simpler way to explain the situation: When the cost of Ethereum (ETH) rises, such as reaching $3,000, arbitrage traders will actively buy ETH. They continue purchasing ETH until the value of ETH compared to DAI in the pool matches the current market price. This trading activity maintains the balance between the pool’s ETH and DAI ratio and the wider market. However, it could impact your holdings in the process.

Following the price adjustment and arbitrage actions, you could find yourself with approximately 0.816 Ether (ETH) and 2,448 DAI, which would be equivalent to a total value of about $4,896 if withdrawn from the pool. On the other hand, if you had simply kept your initial 1 ETH and 2,000 DAI outside of the pool, you would have possessed an equivalent value of $5,000.

The difference, $104, is your impermanent loss. 

In this illustration, we observe that changes in prices and the practice of arbitrage can influence a liquidity provider’s earnings. It is possible for the overall worth of your possessions to rise, but the gain could potentially be smaller compared to what it would have been if you had kept those assets individually.

In simpler terms, Impermanent Loss refers to the opportunity cost experienced when you provide liquidity to a pool, which causes you to miss out on potential gains that could have been earned if you had held onto your assets instead.

Have you heard? In times of intense market fluctuations, certain liquidity pools have suffered impermanent losses that exceeded 50%. This highlights the significance of choosing asset combinations and approaches thoughtfully to minimize such potential risks.

How impermanent loss occurs

Let’s take a look at another example. 

Picture this scenario: You contribute 1 Ether (ETH) and $100 in US Dollar Tether (USDT), assuming each ETH is equivalent to $100 for our discussion’s ease. Now, the pool holds the same total worth of these two types of assets.

If Ethereum (ETH) prices reach 200 US Dollars (USDT), arbitrage traders will become active to keep the balance within the pool. They’ll invest more USDT while acquiring less ETH to preserve the ratio between the two. This, in turn, results in a lower portion of ETH for you and an increased share of USDT in the pool.

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:

Here, the 14.07% figure signifies the possible decrease in value when offering liquidity versus simply owning the assets.

As an analyst, I’d rephrase it this way: The current loss I’m experiencing is “temporary” as it stems from a temporary imbalance in the ratio between ETH and USDT prices. Once these prices revert to their original equilibrium, my loss will vanish. However, during this price divergence period, the change in relative prices and the subsequent adjustment of the liquidity pool has resulted in an actual decrease in value.

As a researcher delving into the fascinating world of decentralized finance, let me share an interesting fact: The Uniswap protocol, introduced by Hayden Adams in November 2018, significantly contributed to the widespread acceptance of automated market making. It was through Uniswap’s execution and educational materials that the concept of impermanent loss became widely recognized. As liquidity providers engaged with this platform, they began to grasp the influence of price disparities on their pooled assets.

Tools and calculators for calculating impermanent loss

CoinGecko provides a user-friendly Impermanent Loss Calculator that allows users to easily calculate potential losses. All you need to do is input the original and current prices of your assets, and it will instantly show you an estimate of your possible impermanent loss. This tool is particularly helpful for newcomers who are looking for a simple way to evaluate their risks.

GitHub’s impermanent loss calculator

A handy resource to consider is GitHub’s Temporary Loss Calculator, an open-source tool that offers in-depth analysis. You can use this tool by inputting various parameters to grasp how different factors influence temporary loss. It serves as a valuable tool for those seeking a more comprehensive understanding of the underlying 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.

Using these tactics will help you effectively control and minimize the threat of temporary losses, thus making your liquidity offering more lucrative and safer.

Risks and rewards of providing liquidity

In discussions about liquidity provision, impermanent loss is a frequently mentioned risk. Essentially, as the difference in prices increases, so does the potential for impermanent loss.

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

Decentralized Finance (DeFi) systems function using self-executing programs known as smart contracts. However, it’s important to note that these are not flawless. Issues like coding errors, security loopholes, or potential exploits in the smart contracts can result in substantial financial losses. Despite thorough audits, there still exists a risk of unexpected problems arising.

Furthermore, it’s important to note that the legal landscape for Decentralized Finance (DeFi) continues to develop. Any modifications in laws could influence how DeFi platforms operate and whether specific actions are lawful, possibly resulting in assets being frozen or encountering complex legal issues.

Additionally, when markets become excessively volatile, liquidity may diminish, leading to challenges in promptly withdrawing funds without experiencing substantial price changes. Consequently, this situation could potentially leave investors stuck in positions that are rapidly depreciating in value.

So, what makes it worthwhile? 

In essence, the main focus is on trading fees. Those who contribute to the liquidity pool are rewarded with a share of the fees produced by trades within that pool. Highly active pools can yield significant fee earnings, creating a consistent and potentially profitable income source.

On several Decentralized Finance (DeFi) systems, users are often rewarded with native platform tokens. These bonuses can substantially increase the total profit gained from investment, particularly if the token’s worth increases over time.

Have you heard? In large-scale liquidity pools, it’s quite frequent for liquidity providers to reap annual percentage yields (APY) exceeding 20%, sometimes even more, contingent on the platform and the selected pool. However, these returns should be balanced against potential hazards, including impermanent loss and susceptibilities in smart contracts.

As a token analyst, I often observe that governance tokens are distributed to liquidity contributors, enabling them to have a say in the strategic decisions within a protocol. The advantage of this involvement is multifaceted: it empowers you to shape the course of the platform’s development and potentially reap rewards from its expansion.

Furthermore, engaging with liquidity pools could potentially open up opportunities for yield farming as well. Yield farming offers extra income through rewards given out by DeFi platforms to encourage the provision of liquidity.

Due to various factors, numerous individuals consider the potential for temporary setbacks as acceptable, given the possible benefits – similar to farmers planting crops in areas susceptible to flooding.