Elk Academy Lesson 4: Impermanent Loss & How to Avoid It
Congratulations, Elksters! You’ve successfully made it through the basic lessons covering the fundamental concepts behind DeFi: liquidity pooling, yield farming, and tokenomics. You are well on your way to becoming “that guy” at parties and family gatherings. By now, you should be able to swap, LP, farm, and even evaluate tokens with confidence.
Now, it’s time to delve into some more advanced concepts and strategies, which will help you achieve your investing goals, whether they involve maximizing gains, minimizing losses, or simply developing a healthy portfolio based on your risk tolerance. We’ll start with one of the biggest hidden risks that liquidity providers take on: impermanent loss.
What is impermanent loss?
Impermanent loss (or “IL”) describes an excess loss that occurs when the price of tokens in a liquidity pool diverge. The loss is relative to the hypothetical value of those same tokens if they were simply held rather than pooled together.
As you’ll recall from the first lesson on liquidity basics, the price of two tokens is set by their ratio within the pool. To return to our fruit analogy, as apples are traded for bananas, they become more scarce, such that each apple is worth more bananas. As the price of one token goes up or down relative to the other, the automated market maker (AMM) will adjust the number of tokens in your LP to reflect this new price ratio, keeping your percentage of the pool’s liquidity in tact. However, whenever the ratio changes, there is a small loss that occurs.
The loss is deemed “impermanent” because if the two tokens revert to the original price ratio, the effect will be cancelled out. You can think of the liquidity pool as a rowboat filled with water: if one side of the boat becomes too heavy, a little water spills over, offsetting some of the gains from transaction fees and farming rewards that you’ve earned.
There’s a bit of rosy thinking folded into the name here, since it’s quite possible that the price of one token will never recover relative to the other (or maybe you will be able to fit into that wedding tuxedo again, you never know!).
Since the loss is not realized until you break your LP tokens, it is only theoretical until then. Of course, the same can be said about any loss in token value, which is why the name is slightly misleading.
How can I calculate impermanent loss?
The formula is fairly complicated, but thankfully there are plenty of free impermanent loss calculators online. It’s worth spending a few minutes playing around with one of these calculators to get a sense of how it works. To get a general understanding though, this nifty graph comes in handy:
The point where the line touches the top of the graph represents the price ratio at the time of deposit.
It’s crucial to recognize that IL occurs when token prices diverge in any direction. If both tokens go up in price, but the price of one token increases more sharply, you still suffer IL. In that scenario, you can think of IL as the opportunity cost of pooling liquidity instead of holding your tokens individually. In the other direction, if both tokens go down in value, but one falls sharply, the overall loss becomes magnified.
One important exception: if the two tokens fall or rise the same relative amount, such that the price ratio between them matches the price ratio at the time of deposit, there will be no impermanent loss. So, for example, let’s say Token A is worth $10 and Token B is worth $1 when you enter a pool, but when you withdraw your liquidity, Token A is only worth $5 and Token B has fallen to $0.50. In each case, the price ratio of Token A to Token B is constant at 10:1, so no impermanent loss has occurred. What has occurred is just called loss.
How can I avoid impermanent loss?
There are several scenarios where IL can be avoided or at least minimized. Since the negative impact of IL increases the more token prices diverge, choosing a volatile token for your liquidity pairing increases your risk of IL. Likewise, some tokens tend to track with one another fairly well (for example, the primary chain token and the farming token for that chain’s main DEX will often move in tandem), which can reduce IL.
Patience can also be a virtue here. If you think the starting price ratio between the two tokens will converge again at some point in the future, you can time your withdrawals accordingly. For this strategy, it can be helpful to make a note of the price ratio when you first deposit into the pool so you can check it every so often.
If you want to avoid impermanent loss completely, there are a few options:
- Single token staking. Some protocols offer rewards for taking a single token. Since there is only one asset, there will not be any impermanent loss. There are several variations of this idea, but in general the APRs tend to be lower since the risk is reduced.
- Staking stablecoins, mirror tokens, or pegged assets. There are instances where the price ratio of two tokens is fixed, in which case no IL will occur. Pairing two stable tokens pegged to the US Dollar (say, USDT and USDC) is an example. Other examples involve a wrapped token paired with the unwrapped version. In these cases too, however, the APRs are generally low since there is little risk involved.
- Insurance. There are a small handful of platforms that have developed unique systems for offsetting the effects of impermanent loss by compensating liquidity providers for their losses, offering what is effectively an insurance policy for IL. Elk just so happens to be one such platform, offering Impermanent Loss Protection (ILP) to all of the liquidity providers on ElkDex pools. With a system like Elk’s ILP coverage, you do not have to settle for tiny APRs to avoid IL
How does Elk’s Impermanent Loss Protection work?
Basically, liquidity providers are paid extra $ELK when they go to withdraw to make up for deposited value lost across both tokens due to IL. As you will recall from our last lesson on tokenomics, there is a fund for ILP written into the token distribution, which matches the pool dedicated to farming rewards. To protect the value of the $ELK token and to incentivize staking, insurance coverage increases daily over a period of time until 100% coverage is achieved (currently, 42 days). If you withdraw from the yield farm earlier, your coverage will be prorated based on the number of days you were in the farm. More details about Elk’s Impermanent Loss Protection can be found here.
By pooling liquidity, staking in a farm, and receiving insurance against impermanent loss, you are benefitting from a triple dip of earning. Hard to argue with that.