Impermanent loss is a hypothetical loss that can occur when providing liquidity to a decentralized exchange or DEX. DEXs are a common and popular way to trade different tokens without an intermediary. While the user experience with DEXs has become similar to centralized exchanges, behind the scenes they have very different architecture.
DEXs use automated market makers (AMMs) to facilitate trades that enable users to trade cryptocurrencies with each other based on an underlying smart contract. These smart contracts hold a liquidity pool of cryptocurrencies, which are reserves for each trading pair.
When a user wants to trade on a DEX, they deposit funds into the liquidity pool and receive liquidity pool tokens in return. These tokens represent the user's share of the liquidity pool and can be traded or redeemed at any time. The price of each liquidity pool token is determined by the ratio of each cryptocurrency in the pool, and it can fluctuate based on market demand.
When a trade is executed on a DEX, the AMM algorithm adjusts the price of the trading pair based on the change in the liquidity pool's ratio. This ensures that the pool's value remains constant, and users can buy and sell cryptocurrencies at a fair market price.
In this post, we will discuss DEXs, yield farming, and impermanent loss.
Impermanent loss is a phenomenon in yield farming that arises due to price fluctuations of the two assets in a liquidity pool. It is a term used to describe the difference in the value of an investor's assets in a liquidity pool compared to what they would have earned had they held onto their original assets. In other words, it's the loss incurred by a liquidity provider when compared to holding onto their assets.
Impermanent loss arises when the price of the two assets in a liquidity pool changes, and one asset increases or decreases more than the other. This leads to a divergence between the value of the assets in the liquidity pool and their value outside the pool. As a result, the liquidity provider may lose some of their assets' value when they withdraw their liquidity from the pool.
Impermanent loss can have a significant impact on the overall yield of a liquidity provider in yield farming. While earning additional tokens in yield farming can be profitable, the impermanent loss can significantly reduce the profitability of the investment. The extent of the loss depends on the volatility and correlation of the assets in the liquidity pool. The greater the volatility and the lower the correlation between the assets, the higher the impermanent loss.
Let's say a liquidity provider wants to provide liquidity for the ETH-USD pair on a decentralized exchange. They deposit $10,000 worth of ETH and $10,000 worth of USD into the liquidity pool. At this point, the price of ETH is $2,000.
Now, let's say that the price of ETH starts to increase rapidly and it reaches $3,000. As a result, more traders start buying ETH on the exchange, which decreases the pool's ETH reserves.
Liquidity providers want to maintain the ratio of your deposited assets in the pool, which is 50/50 in this case. To do so, liquidity providers will need to add more ETH to the pool, which means buying more ETH with USD. However, because the price of ETH has increased, they will need to buy more ETH than what they initially deposited to maintain the ratio.
Let's say the liquidity provider adds $5,000 worth of ETH to the pool to maintain the ratio, and the new price of ETH is $3,500. At this point, the value of the initial $10,000 deposit of ETH has increased to $17,500, while the value of the USD deposit has remained at $10,000. This means that if they were to withdraw your funds from the pool at this point, they would only receive $27,500. This is a potential loss when compared to the $30,000 they would have received if they had just held the assets in their respective tokens.
This is an impermanent loss. It's called "impermanent" because it only occurs when the price of one asset changes relative to the other, and it disappears when the prices return to their original ratio. In this example, if the price of ETH were to decrease back to $2,000, the value of the initial deposit of ETH would also decrease to $10,000, and the liquidity provider would be able to withdraw their initial deposit of $20,000.
Impermanent loss is a phenomenon that occurs when liquidity providers provide liquidity to an AMM DEX by depositing an equal value of two different assets into a liquidity pool. This loss is called "impermanent" because it is not permanent, as it depends on the market price fluctuations of the two assets.
The loss occurs when the price ratio between the two assets in the pool changes compared to the price ratio of the same two assets outside the pool. In other words, when the price of one asset goes up or down compared to the other asset, the liquidity providers will end up with less of the asset that increased in value and more of the asset that decreased in value. This leads to a reduction in the value of the liquidity providers' shares in the pool compared to holding the two assets outside of the pool.
It is important to note that impermanent loss only affects liquidity providers, not traders who buy or sell the assets in the pool. Traders benefit from the liquidity provided by liquidity providers and pay a trading fee that is distributed among the liquidity providers. Liquidity providers should carefully consider the potential risks and rewards of providing liquidity to a pool before making any deposits.
TheseYield farming and staking are two popular methods for users to earn rewards by providing liquidity to a pool. However, Yield Farming and Stakingthey differ in the way they generate impermanent loss.
In yield farming, liquidity providers deposit their tokens into a liquidity pool and receive liquidity pool tokens in return. These LP tokens represent the liquidity provider's share in the pool and can be used to redeem their share of the pool's assets at any time. The liquidity providers earn rewards in the form of fees charged by the DEX for trades executed on the pool. However, the value of the liquidity provider’s tokens may change over time due to fluctuations in the price of the assets in the pool. If the price of one asset in the pool increases relative to the other asset, liquidity providers will experience impermanent loss. The impermanent loss occurs because their tokens become more heavily weighted towards the asset that has decreased in value.
In staking, stakers lock up their tokens in a smart contract in exchange for staking rewards. Impermanent loss is less likely to occur in staking because stakers are not providing liquidity to a pool. However, stakers are still exposed to price volatility, which can lead to impermanent loss if the price of their locked-up token falls relative to the token they receive as a reward.
Both yield farming and staking can hypothetically lead to impermanent loss for liquidity providers. The level of impermanent loss depends on various factors, including the price volatility of the assets in the pool, the trading volume, and the liquidity pool's fees.
Impermanent loss is a risk that cannot be completely eliminated in the world of DeFi. However, calculating potential impermanent loss can help liquidity providers make informed decisions about whether to add funds to a particular liquidity pool.
The formula for calculating impermanent loss estimation is relatively straightforward, but it requires an understanding of the relationship between the assets in the pool. The calculation involves comparing the current prices of the assets in the pool to their prices at the time of deposit.
The first step is to determine the initial ratio of the assets in the pool. This is the ratio of the value of Asset A to the value of Asset B at the time of deposit. Then, the current ratio of the assets in the pool must be calculated. This is the ratio of the current market value of Asset A to the current market value of Asset B.
The next step is to determine the percentage change in the price of each asset. This is calculated by subtracting the current price from the initial price and dividing the result by the initial price.
Finally, the impermanent loss estimation can be calculated using the following formula:
(1 - ((initial ratio / current ratio) * (1 - percentage change of Asset A) / (1 + percentage change of Asset B))) * 100
This formula provides an estimation of the impermanent loss as a percentage of the total deposited value. If the estimation is high, it may indicate that the liquidity pool is not a good fit for the liquidity provider. However, it is important to keep in mind that impermanent loss is just one of several factors to consider when evaluating a liquidity pool.
Impermanent loss is an inevitable risk for liquidity providers in decentralized exchanges. However, several strategies can be employed to minimize or avoid its impact altogether.
When providing liquidity, it is wise to select stablecoin pairs such as USDC-DAI or USDT-DAI because the value of the assets in the pair is pegged to the US dollar. The smaller the deviation from the peg, the lower the risk of impermanent loss. It is important to note that providing liquidity for stablecoins generally generates lower rewards on most DEXs.
Pairs with high trading volumes are less likely to experience extreme price swings that can lead to impermanent loss. Liquidity providers can mitigate this risk by selecting pairs with higher trading volumes.
Some DEXs, such as Uniswap V3, allow liquidity providers to utilize strategies such as concentrated liquidity, which is concentrated around a certain price range. This approach reduces exposure to price changes outside the range and can help to minimize impermanent loss.
Liquidity providers can hedge their risk by simultaneously staking their assets in a yield farming pool. By doing so, the rewards earned from yield farming can offset any impermanent loss incurred as a liquidity provider.
Impermanent loss is dynamic, and its impact can change over time. Monitoring the liquidity pool regularly and adjusting as necessary is essential.
In conclusion, impermanent loss is a risk that liquidity providers face when they provide liquidity to an AMM DEX. It is a loss incurred when the price of the two assets in a liquidity pool changes, and one asset increases or decreases more than the other. The loss occurs because liquidity providers will end up with less of the asset that increased in value and more of the asset that decreased in value, leading to a reduction in the value of their shares in the pool.
While earning additional tokens in yield farming can be profitable, the impermanent loss can significantly reduce the profitability of the investment. The extent of the loss depends on the volatility and correlation of the assets in the liquidity pool. The greater the volatility and the lower the correlation between the assets, the higher the impermanent loss.
It is important to note that impermanent loss only affects liquidity providers, not traders who buy or sell the assets in the pool. Traders benefit from the liquidity provided by liquidity providers and pay a trading fee that is distributed among the liquidity providers. Therefore, liquidity providers should consider the potential risks and rewards of providing liquidity to a pool before making any deposits.
An impermanent loss protector is a DeFi tool designed to mitigate the risk of impermanent loss for liquidity providers. It provides protection against the potential loss of value caused by price fluctuations in a liquidity pool. The impermanent loss protector can help liquidity providers reduce their exposure to impermanent loss, ultimately allowing them to earn more profits. It offers a hedging mechanism that allows liquidity providers to protect their capital by effectively insuring their position against price fluctuations.
It is impossible to completely avoid impermanent loss, as it is an inherent risk associated with liquidity provision in DEXs. However, some strategies that can potentially minimize impermanent loss include carefully selecting trading pairs and avoiding extremely volatile assets. Additionally, impermanent loss protectors and hedging tools can help mitigate impermanent loss's impact.
Staking involves locking up tokens in a smart contract in exchange for rewards. Due to the fact that stakers are not providing liquidity for a pool, there is less likelihood of impermanent loss. However, stakers are still exposed to price volatility, which can result in impermanent losses if the price of their locked-up token drops relative to the token they receive.