Providing Crypto Liquidity & Impermanent Loss Explained
Since the launch of decentralized exchanges (DEXs) with pioneers like Bancor and Uniswap and the rise of Decentralised Finance (DeFi) in summer 2020, owners of crypto assets can generate additional passive income by providing their funds as liquidity. But also term impermanent loss (IL) has been thrown around in every other discussion and scared off many people from acting as liquidity providers themselves.
In this article, we want to explain the basic concept of providing liquidity and the risk of impermanent loss to you in an objective manner so that you can better understand how to provide liquidity to a decentralized exchange and what risks you are facing through IL.
Let us first clarify in which cases you might face impermanent loss. Most decentralized exchanges are automated market makers (AMMs). It is the most common form of a decentralized exchange first developed by Bancor where the asset price is not defined by an order book but a mathematical formula.
The most used formula is “x * y = k”, where “x” is the amount of token 1 in the liquidity pool, and “y” is the amount of token 2 and “k” is a fixed constant, meaning the pool’s total liquidity always has to remain the same leading to pools consisting of the equal ratio between two tokens (50%:50%). For the users of the AMMs, it is important to have as much liquidity as possible as this will lead to lower slippage.
The most prominent DEXs that use this model and therefore pose the risk of impermanent loss are Uniswap, Sushiswap, Bancor, Pancakeswap, Terraswap, and Thorchain. Bancor since Version 2.1 and Thorchain since MCCN offer “IL insurance” and to mitigate the risk for their LPs.
You can read more about the detailed mathematical model and its implications here: https://medium.com/finnexus/understanding-the-xyk-model-of-pooled-liquidity-7340fdc20d9c
The core concept of AMM-based DEXs is liquidity pools. Any pool consists of two equivalent values of two tokens, for example, 50% DAI and 50% ETH in the ETH/DAI pool. Liquidity providers (LPs) are the ones that add their capital to those pools that traders (who want to exchange DAI and ETH) can trade against. As a reward, LPs receive trading fees (e.g. Uniswap V2 charges 0.3% which go directly to the LPs) and in some cases also liquidity mining incentives on top (e.g. Sushiswap rewards SUSHI to LPs in many of its pools).
Typically liquidity providers are investors that want to put their digital assets to work in order to achieve additional passive income through fees and other rewards. There are also other reasons like providing liquidity for your own project’s tokens or as a specific strategy (e.g. automated profit-taking).
When you provide liquidity you typically need to provide both assets (in our example ETH & DAI) in equal proportions. This means that if you provide 10000 DAI (equaling $1000) you need to also provide $10000 in ETH (let’s say 5 ETH when 1 ETH = $2000). In some cases (like Thorchain) you can also only provide one asset but the protocol will automatically sell 50% into the second asset to again achieve a 50%:50% split.
You then own a certain percentage/share of the pool (let’s say 1%) as a ratio of your liquidity to the total pool liquidity, as proof you get Liquidity Pool Tokens (LPTs) in return which in some cases can be staked for additional rewards (liquidity mining). Then, when any trade occurs within the pool, the trader pays a transaction fee which is then transferred to you directly into your share of the pool as a reward.
The risk of impermanent loss
One risk Liquidity Providers have when staking their assets in a Liquidity Pool is impermanent loss (which would better be called divergence loss) which occurs when the price of your deposited assets change compared to when you deposited them and to each other (one asset being volatile compared to the other). The bigger the change, the higher the impermanent loss. This loss is temporary as long you stay in the pool (therefore impermanent) and only manifests once you withdraw your funds from the pool (becoming permanent).
Whenever the price of one asset in the liquidity pool changes (like in our example ETH rises) in the market, arbitrage traders or bots come in and add DAI to the pool and remove ETH from it to sell it in the market for profit until the ratio reflects the current market price.
So, let’s say the price of 1 ETH rises from $2’000 to $2’500. Before the price rise and the arbitrage occurs our pool was worth $20’000 but after it, due to the arbitrage the value of your total holdings is now $22’360, consisting of 3.7 ETH and 11’180 as your ETH was sold for DAI to regain a 50%:50% split. If you would have hodled your funds outside a liquidity pool, you would own 5 ETH worth $12’500 and still $10’000 in DAI and therefore $22’500 in total. On the paper, you lost $140 equaling about 0.6% of impermanent loss. In all of this, your share of the liquidity pool stays the same.
If you ETH has appreciated 100% in value instead of “only” 25%, you impermanent loss would equal 6% instead of 0.6%. To calculate a few examples on your own, you can use an online tool such as this one: [Impermanent Loss Calculator](https://decentyields.com/impermanent-loss-calculator)
Alternative here are some basic pre-calculated examples:
- 1.25x price change = 0.6% loss
- 1.50x price change = 2.0% loss
- 1.75x price change = 3.8% loss
- 2x price change = 5.7% loss
- 3x price change = 13.4% loss
- 4x price change = 20.0% loss
- 5x price change = 25.5% loss
As you can also see in the below diagram, the impermanent loss increases with the size of the divergence between the initial price and the current price. Be aware that it does not matter if the asset price diverges upwards (price rise) or downwards (price loss).
What does this mean for me?
What we left out in the above examples are the trading fees that we have gained during our time as a liquidity provider and potential additional rewards based on a liquidity mining incentive program. If the impermanent loss you suffered is mediocre, there is a high chance that you still outperformed any HODL strategy. As you can also see, the longer you are in a lucidity pool, the higher your rewards will be, making it a long-term strategy.
Especially in parabolic markets, when asset prices rise by several hundred percent, being in a liquidity pool can make you rekt but tendentially the risk of impermanent loss is overstated based on examples in specific market conditions for specific digital assets.
In some cases, a viable strategy can even be to seek impermanent loss. Assuming you believe in the slowdown of a bull market and want to take profits, you can enter a pool with a stable coin (e.g. USDC) and the asset you want to take profits in (e.g. RUNE). When RUNE climbs in price, the pool will automatically sell it for USDC and therefore taking profits for you.
How to mitigate impermanent loss
You can mitigate your risk of suffering impermanent loss by choosing liquidity pools that are either stable (in stable coin pools the impermanent loss is typically 0 if the coins hold their pegg) or by choosing a pool where you are equally bullish on both assets (they rise in price in tandem again nullifying your temporary losses).
Some decentralized exchanges like Bancor, Dodo, and Thorchain offer insurance against impermanent loss (Bancor, Thorchain) compensating your potential losses or offer slightly different algorithmic models that allow for single-token exposure (also Bancor and Dodo’s PMM model).
You can read more about these models here:
Bancor: [FAQs — Bancor Network](https://docs.bancor.network/faqs#2-impermanent-loss)
Thorchain: https://twitter.com/thorchain/status/1360404349004902400?lang=en (same design as Bancor)
We advise you to make yourself comfortable with the concept of impermanent loss (without demonizing it) and do a few test calculations before you enter any liquidity pool taking also into account the rewards that you generate over time. Also, think in advance about the meta-strategy that you are following and the overall crypto market conditions.
About Qi Capital
Qi Capital is a group of like-minded and experienced individuals from around the globe, sharing two common objectives: providing insights about crypto and DeFi, and proactively working with ambitious teams on the future of decentralized finance. Our core principle is to promote and foster individual creativity, growing not only as a group but also as creative thinkers and builders. To learn more about us, check out our website www.qicapital.org and our “Qi Podcast” via www.buzzsprout.com/1729379/ or engage with us on Twitter: @QiCapital.