Exploring the cryptocurrency world carries certain risks, particularly when making investments or speculating. Those who are active in the DeFi space will know that impermanent loss is a real risk. Losses can pile up incredibly quickly; thus, caution remains advised when dealing with decentralized finance.
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The Concept Of Impermanent Loss
For those unfamiliar with the concept of impermanent loss, a brief explanation is in order. When one interfaces with DeFi protocols, users often have to deposit tokens into an “asset pool”. If the value of the token changes compared to when they were deposited – in this case, a price decrease – one will suffer from impermanent loss.
It is very likely users who provide liquidity to DeFi protocols will deal with impermanent loss sooner or later. This concept is primarily applicable to AMM – or automated market maker – protocols, such as Uniswap, SushiSwap, and so forth. While there is a chance users who provide liquidity will earn a profit for doing so, the market can always swing the other way.
When an impermanent loss occurs, the user will always have a lower USD value on their assets compared to before. This gap can be small, but it can quickly grow over time. Receiving less value back for providing liquidity is counterproductive, yet it happens a lot more than most DeFi enthusiasts may think. All crypto assets are volatile, but those with smaller market capitalizations perhaps even more so than others.
Some Crypto Assets Are Immune
Although impermanent loss is not something to take lightly, users can circumvent it with relative ease. The main reason for depositing volatile assets into AMM liquidity pools is their high trading volume, or substantial APY Great risks provide great rewards. Still, not everyone will benefit from blindly depositing any asset into these liquidity pools.
Using stablecoins or wrapped versions of a coin with a relatively stable value can help circumvent impermanent loss. A stablecoin will always maintain its value, making it far less risky to contribute to AMM pools. It will often provide a lower APY or fewer trading fees, but it can still provide a stable revenue stream.
In the end, it comes down to figuring out one’s risk appetite. Is it worth chasing high trading fee rewards or a high APY if one’s asset can lose 10% of its value in a matter of hours? Not everyone is cut out for dealing with impermanent loss, as the situation can grow dire very quickly.
Examples Of Impermanent Loss
An excellent example of how traders can trigger impermanent loss is by providing liquidity.
Let’s assume you deposit 1 Ether and 1000 USDT in a liquidity pool on an AMM DeFi platform. On most AMm platforms, users need to provide liquidity for two assets, and that liquidity needs to be the same on both ends. Suppose Ethereum has a value of $1,000. The user needs to deposit $1,000 in USDT as well. As such, a user deposits $2,000 worth of liquidity into the pool.
More often than not, users are competing with other liquidity providers to share the trading fees. In our example, we will assume the pool has 500 ETH and $500,000 in USDT after our deposit. Our deposit will then represent 1/500th of the pool or 0.2%.
In a perfect world, the value of Ethereum would rise to $1,500. To “counter” this price rise of one asset in the pool, traders will add USDT to the pool and remove ETH to reflect the current market price. AMM DeFi platforms have no order books. The price of pooled assets relies solely on the ratio between ETH and USDT in this pool. A rising ETH value means there needs to be fewer ETH in the pool, and more USDT needs to enter.
For those who provide liquidity, this introduces crucial changes. When withdrawing liquidity, you will not get your initial 1 ETH and $1,000 in USDT back. Instead, you will receive fewer ETH – due to its value increasing – and more USDT to compensate for this difference. For simplicity, we will assume traders pushed the pool to 400 ETH and $600,000 in USDT. Of this pool, we still own a 0.2% stake.
On paper, users will still make a profit in this scenario. Ethereum rose in value, and they received a bit more USDT back initially deposited. After all, our 0.2% of the pool represents 0.8 ETH – at $1,500 , that is a $1,200 value – and $1,200. Most traders see $400 in profit as a win-win situation, but there is a caveat.
The withdrawal of liquidity from a pool after a price rise reflects less profit than merely holding the initial assets in a wallet.
Assuming we kept our 1 ETH and $1,000 in USDT, the recent Ethereum price rise would give us $1,500 in ETH and $1,000 in USDT. That is $100 more than our effort to provide and withdraw liquidity – both of which are subject to paying fees on the Ethereum network.
This $100 difference is what is known as impermanent loss. It is not a net loss per se, but it is still a notable difference in profit.
Quick Calculations To Estimate Impermanent Loss
As is often the case, there are ways to gauge one’s impermanent loss before contributing to liquidity. The calculation is not too complicated but remains viable to this very day.
- 1.50x price change: 2% loss
- 2x price change: 5.7% loss
- 3x price change: 13.4% loss
- 4x price change: 20% loss
It is evident that the higher the price change is, the bigger one’s impermanent loss will be. These figures are primarily educational, as HODLing is not for everyone. Moreover, one has to consider any fees to be paid when providing/withdrawing liquidity, which further eats into one’s profits.
After reading the above, one may wonder why anyone provides liquidity to AMM DeFi protocols. Even though the impermanent loss is a factor, users often prefer providing liquidity over HODLing. In return, they receive either trading fees, speculative DeFi assets, or other rewards. Furthermore, they still benefit from a rising asset price, albeit less outspoken than those not providing any liquidity.
As long as the provided asset’s value remains stable or can go up in value, providing liquidity is a worthwhile option. However, entering a pool when an asset is near its all-time high is a much riskier decision. Always evaluate the pros and cons carefully before making any commitments.