Impermanent Loss — A Simple Explanation
We are sure that you must have heard of various types of losses in the crypto world, but what is Impermanent Loss? Ever been warned by friends about this type of loss before providing liquidity? How significant is it to understand this terminology?
As you move through this article, you will be able to get answers to the questions above.
Providing liquidity has become a popular practice in the crypto industry. It is not just a means to earn rewards, but this is what keeps Decentralized Exchanges like Uniswap, Sushiswap, etc. functioning without the need to have a centralized order book model. Liquidity provision is the core of the Automated Market Making protocol, which ensures that tokens can be swapped/bought on decentralized and non-custodial exchanges rather than centralized custodial exchanges.
Before we move to the subject of Impermanent Loss, here are a few pointers on Liquidity Providers:
- A liquidity provider is a user who funds a liquidity pool with crypto assets they own to facilitate trading on the platform and earn passive income on their deposit.
- The percentage of rewards obtained by the liquidity providers depends on the amount of liquidity they provide.
- Liquidity is provided in token pairs: ETH-UNI for example represents an Ether and UNI pair. Users have to have equal amounts of both the tokens to provide liquidity.
- Every time trade on the provided pair is executed, the liquidity provider would receive compensation for having funded the pool.
Sounds simple? Well, it is not exactly that straightforward.
As with several crypto activities, providing liquidity might be riskier at times due to certain factors, one of which is: impermanent loss.
At times, liquidity providers may find that some of their coins have gone missing!
This behavior could be the result of a phenomenon called Impermanent Loss.
Now that I have caught your attention, let us take a closer look at this phenomenon.
What is Impermanent Loss?
- As the terminology suggests, it refers to the temporary loss of funds while providing liquidity through an asset.
Here is an example of how Impermanent Loss works:
- Consider Stage 1, where the liquidity provider is providing liquidity. In our example, we consider that Token-1 is a stable coin(like USDT) and Token-2 is a volatile token called XYZ.
- The price of token-2 while providing liquidity is $500, so the total price for the liquidity provided becomes $20000 as the user provides 10000$ worth of the stablecoins and 20 XYZ tokens.
- Due to the volatile nature of the XYZ token, arbitrageurs can cause a shift in the price of the token by taking advantage of arbitrage trading.
Quick notes on Arbitrage Trading:
Arbitrage trading refers to profiting from price differences on different cryptocurrency exchanges.
Post arbitrage, the total value of the users’ liquidity pool is $20976.59. This value is derived after applying certain market formulae. Whereas if the user would have simply held the asset, the value of the asset could have been $21000.
The difference in these values(~23$) is the impermanent loss to the LP. This is why impermanent loss is highlighted as the difference between holding an asset and providing liquidity through it.
Here is a reference table to understand the series of events in a better manner.
Why is the loss called impermanent and how does it affect the profits of the LP?
The loss is called impermanent because the user does not need to remove the liquidity post the loss immediately. If they do so, the loss becomes permanent. Instead, once the price of the volatile assets fluctuates back, the LP’s total price becomes balanced.
If we take a closer look at the image(Image Credits: Uniswap Medium Article) below, if the price of an asset goes up to 500%, then the LPs can face a loss of up to 25%. In such scenarios, the profits of the liquidity provider are taken away.
The above chart shows the comparison between prices when you HODL(hold the assets for long) vs when you provide liquidity.
However, despite the threat of impermanent loss, there is a silver lining for all the liquidity providers. Let us understand how:
- LPs (Liquidity providers) mainly collect fees from the trading that involves a liquidity pool. For example Uniswap, traders are required to pay a 0.3% fee for trades that are distributed between the LPs.
- This means that the LPs can make money even when they are undergoing an impermanent loss if the Impermanent Loss < Profit made from fees.
- Many of the liquidity pools also provide additional incentives in the form of native tokens through the practice of Liquidity Mining or Yield Farming.
There are other DeFi solutions like Curve and Balancer that provide different types of Liquidity Providing options that can minimise Impermanent Loss.
In conclusion, it is wise to research the different Liquidity Provision options before jumping straight into one of the most popular ones. You should also keep in mind the kind of assets that you are holding and whether they would be good long-term hold assets or would it be more appropriate to provide liquidity using them.
With so many DeFi solutions and protocols coming up in the space of liquidity, there is a lot of scope for innovation and creativity. Our product, CardWallet aims to tap this space of innovation and provide something unique and exciting to our consumers.