IMPERMANENT LOSS, WHAT IS IT AND HOW IT OCCURS?
Definitions:
AMM’s: Automated Market Makers (AMMs) were first described in 2016 bare software-controlled, autonomous decentralized exchanges where the prices of the assets held in a trading pool are controlled by an underlying algorithm to maintain liquidity Ratio (E.g.: 50 %- 50%).
LP’s: The liquidity in each trading pool is provided by so-called Liquidity Providers (LPs), who typically deposit equal amounts of two assets per pool.
Arbitrageur: arbitrageur is a type of investor who attempts to profit from market inefficiencies.
What is Impermanent Loss
➢ In Simple terms: Difference in price, between holding tokens in AMM’s and between wallet, which occurs when price of token fluctuates in AMM’s in any direction.
➢ Impermanent loss becomes permanent loss when you withdraw funds at less value than invested.
➢ Impermanent loss can be either positive or negative.
➢ Larger the Liquidity pool, higher the price fluctuation.
Example:
When you invest in Stock Market, in multiple stocks, the price fluctuates. There may be increase in value for few, and decrease for others. This is impermanent loss. At time of withdrawal of funds, the total value, might be less than value of investment. This becomes permanent loss.
Although this is not the exact analogy, I have tried to simplify the concept.
Impermanent Loss in DeFi (How it Occurs)
➢ If you Invest in 2 deposits in AMM Liquidity Pool at given value. Note: AMM’s are disconnected from External markets. Price change in Tokens does not affect the value in AMM’s. AMM’s are controlled by an algorithm to maintain Liquidity Ratio.
➢ Now, as price of One asset increases externally, an arbitrageur / Algorithm trades (sell / Buy) one deposit for another in LP, ensuring the price ratio between them are same as before.
➢ Due to this, there is a price fluctuation in the assets held, which is called impermanent loss. When you decide to withdraw the funds, this becomes Permanent loss.
➢ Note: Practically, we are not including the Trading fees for the assets in LP. If you add this, to the withdrawn funds, the amount might be recovered.
