How to deal with Impermanent Loss?
What Is Impermanent Loss?
Impermanent Loss is the difference in value between putting your tokens in a liquidity pool and you holding the tokens in your wallet. To understand why is there a difference, we need to analyze what are the causes of impermanent loss.
Liquidity Pool — Automated Market Makers (AMM) are smart contracts that help to create a liquidity pool. AMM uses algorithms to price its assets automatically rather than using an order book. The formula each protocol uses may differ. For Uniswap, it uses x * y = k, x is the amount of one token in the liquidity pool, y is the amount of another token and k is the total liquidity, which is a constant.
Wallet — The tokens in your wallet will appreciate or depreciate based on the market value of the token. Any gains or losses will be the difference between the buy price and the selling price.
The downside of AMM is the risk of underperforming the buy-and-hold strategy.
Impermanent loss has the word “impermanent” because it is not a permanent loss unless the individual withdraws from the liquidity pool. If the price of the token is back to the original, the loss will be erased. Hence, it has the name of impermanent loss.
How Does It Occur?
The best way to illustrate impermanent loss is by using an example.
Imagine Alex is interested in a liquidity pool. Assuming he deposits 2 ETH and 200 DAI — the dollar value of 400 USD — into the liquidity pool. With AMM, the token pair deposited needs to be of equivalent value. Therefore, at the time of deposit, the price of ETH is equal to the price of 100 DAI. Additionally, the liquidity pool consists of 20 ETH and 2000 DAI, inclusive of Alex’s deposits. Hence, Alex has a 10% share of the liquidity pool.
So if the price of ETH increases from 100 DAI to 400 DAI, the liquidity pool is no longer 50–50 in value terms. When there is a price difference, the arbitrageurs in the market see an opportunity to make a profit. Because the liquidity pool priced its assets using AMM, the arbitrageurs can buy cheaper ETH from the liquidity pool until the price of ETH is the same for both the market and the liquidity pool. On the other hand, they will add more DAI to the liquidity pool until the ratio reflects the current market price. Because of the arbitrageurs, the liquidity pool’s ratio between the amount of ETH and DAI has changed. Now, the liquidity pool consists of 10 ETH and 4000 DAI.
If Alex wants to withdraw now, since he has 10% share of the liquidity pool, he will be able to withdraw 1 ETH and 400 DAI — 800 USD. He would make a profit of 400 USD. However, if Alex held the 2 ETH and 200 DAI, he would have made of profit of 1,000 USD. Hence, an impermanent loss of 200 USD was incurred.
However, this illustration does not take into consideration the fees Alex would earn from the liquidity pool for providing liquidity. In most cases, the fees earned would compensate for the impermanent loss, making deposits into the liquidity pool profitable.
This is a table of the impermanent losses compared to holding:
- 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
Any price movement — up or down — will result in impermanent loss, and the degree of impermanent loss depends on how much the price shifts.
Closing Thoughts on Impermanent Loss
Impermanent loss may appear to be intimidating at the start. However, there are ways to lower the risk of impermanent loss. One can provide stablecoin as one of the token pair to the liquidity pool — for example, ETH-USDT. The liquidity provider is submitted to just the price change of ETH as the price of stablecoin such as USDT does not move.
When providing liquidity to a liquidity pool with non-stable coin pairing, the liquidity pool usually compensates its liquidity provider with higher APY incentives due to the higher risk involved. Hence, it is likely that the liquidity provider can earn from the liquidity pool despite having impermanent loss due to the high APY of the liquidity pool. However, one has to do its due diligence when providing liquidity into the liquidity pool as the APY received might get affected if the rewards given is in terms of the token of the protocol. It is subjected to a higher risk.
Introducing Tokenize Dual Earn
So, if you are interested to be part of the DeFi participants — liquidity providers, but are afraid of impermanent loss, fret not, as Tokenize will be introducing a scheme similar to liquidity pool mining without exposing users to its downside!
What is Dual Earn?
An enhanced version of Tokenize Crypto Earn Scheme, earning higher APY on a pair of cryptocurrency together!
How does it work?
Similar to Tokenize Crypto Earn, clients can deposit their cryptocurrencies and earn up to 25% APY! Paid out at the beginning of every month, the interest earned is calculated using simple interest. This is an easy way for crypto investors to earn cryptocurrencies while they HODL.
Example
User A wants to participate in the TKX & LINK pair product have to deposit 10 TKX & 1 LINK per unit. If User A wants to purchase 100 units of TKX & LINK pair product, he would need 1,000 TKX & 100 LINK. User A invests 1,000 TKX & 100 LINK in the Dual Earn Scheme on 1/10/2020 will be able to receive an interest of 16.67 TKX & 1.67 LINK on 1/11/2020 and will be able to withdraw on 2/12/2020.
