What is Impermanent Loss?

For Clarity

• Impermanent loss can occur regardless of asset prices increasing or decreasing.
• The prices of assets within a pool are affected by the ratio between them and not (necessarily) by the prices of the assets on external markets.
  1. this is because the assets are managed by the pool’s algorithm, which relies on ratios and not an order book.
  2. this may change, or change more rapidly, over time with the implementation of oracle services by DeFi protocols. See the note at the end of this article.

When considering a liquidity pool’s risk of impermanent loss, keep this in mind:

• the more volatile an asset price, the more prone to impermanent loss a liquidity pool investor becomes
• liquidity pool asset pairs with highly different prices are also prone to impermanent loss

Liquidity Pools: A Quick Review

A liquidity pool is, typically, comprised of two digital assets. Assets are deposited by liquidity providers (LPs) to provide liquidity for DeFi traders and investors within a Decentralized Exchange (DEX). The funds within the pool are managed by an algorithm. This is known as an Automated Market Maker (AMM).

Need a refresher? Learn the basics of liquidity pools, how they work, and associated risks here.

The Math Behind a Standard 50/50 Pool

Decentralized Automated Market Makers (AMMs) like Uniswap (https://uniswap.org/) have deployed a standard mathematical function to keep their pools balanced:

x * y = k

In simple terms, this formula dictates that a liquidity pool’s ratio must be equivalent: the value of token X must equal the value of token Y. Want to take a deeper dive into Uniswap? Read their documentation and learn How Uniswap Works and more advanced topics like Understanding Returns.

Let’s assume a liquidity pool contains two assets: Bitcoin (BTC) and Ethereum (ETH). In a traditional 50/50 ratio pool, like those on Uniswap, liquidity providers (LPs) deposit equal amounts of BTC and ETH to the pool and receive LP Token(s) in return.

As buyers and sellers interact with the pool, the managing algorithm adjusts the prices of each asset based on user activity. For example:

• a user buys BTC from the BTC/ETH liquidity pool
  1. this causes the pool to have fewer BTC due to buying pressure
  2. this causes the pool to have more ETH due to selling pressure

Based on the standard formula, x * y = k, the liquidity pool will increase the price of BTC relative to ETH, so that the pool’s BTC balance/price will regain equality with the pool’s ETH balance/price.

When a user returns their LP Tokens, they receive their proportionate shares of the liquidity pool assets in equal value. As the ratios within the pool may have changed due to trading activity, the proportion of assets may look different at the withdrawal than at the time of deposit.

Let’s adjust our example to a hypothetical Ethereum (ETH) and USDCoin (USDC) liquidity pool. The liquidity pool requires the traditional 50/50 ratio of supplied assets. As we know, liquidity providers will offer an equal amount of the assets when depositing, and they’ll remove an equal amount upon withdrawal.

A note for beginners: USDC is a dollar-pegged stablecoin, so 1 USDC is (generally speaking) typically worth $1 USD. For the purposes of this example, we’ll assume it’s an even $1.00.

Let’s assume that, at the time of deposit, 1 ETH costs $1,000, so it’s equal to 1,000 USDC. In this case, we (the liquidity provider) would deposit 1 ETH and 1,000 USDC into the pool and receive LP Tokens worth $2,000 in return.

• $1,000 of Ethereum + $1,000 of USDC = $2,000

In this example, let’s assume there’s a total of 10 ETH ($10,000) and 10,000 USDC ($10,000), for a total of $20,000. Our LP Token would reflect our 10% ($2,000 out of $20,000) ownership of the liquidity pool.

Now let’s see how activity by other investors and traders in the pool may impact the value of the assets for our liquidity provider.

Let’s assume the price of ETH goes much higher in price throughout the market; on Coinbase or Binance, for example. So 1 ETH is now worth $4,000.

This presents an opportunity for arbitrage traders (arbitrageurs) who would look to capitalize on the price difference between ETH on exchanges and ETH in this liquidity pool. In this example, an arbitrageur would buy ETH from our liquidity pool and sell it on exchanges to make a profit.

This would cause our liquidity pool to see buying pressure for ETH, and selling pressure for USDC. Because of this, the ratio of ETH and USDC in the pool is now changed. Remember, Automated Market Makers (AMMs) are not order books. The price of assets in the liquidity pool is determined by their price ratio.

For the sake of simplicity, let’s assume there are now 5 ETH (vs. 10) and 20,000 USDC (vs 10,000) in the pool, or:

• $20,000 of Ethereum (5 x $4,000)
• $20,000 USDC (20,000 x $1)

Let’s assume we, the liquidity provider, want to withdraw our funds from the pool. Recall that our LP Tokens represent our 10% ownership in the pool, so we are able to withdrawal:

• 5 ETH / 10% = 0.5 ETH
• 20,000 USDC / 10% = 2,000 USDC

Reminder, our original asset ownership was:

• 1 ETH ($1,000) and $1,000 USDC = $2,000

After withdrawal from the liquidity pool, we now own:

• 0.5 ETH x $4,000 = $2,000
• 2,000 USDC x $1 = $2,000

Our assets are now worth $4,000 instead of $2,000. We see that we’ve profited $2,000. Not bad!

Let’s Calculate Our Impermanent Loss

Recall that the price of 1 ETH is now $4,000. Since USDC is a stablecoin, its value is still $1 per USDC. Had we simply held our original investment, instead of depositing to the liquidity pool, we would have:

• 1 ETH x $4000 = $4,000
• 1,000 USDC x $1 = $1,000

Had we simply held our original assets, we would have a value of $5,000 instead of $4,000.

We can see that holding our original investment as single assets in our wallet would have been the most profitable option. This difference of $1,000 is the impermanent loss, made permanent if/when we withdrawal our funds from the liquidity pool.

Additional Clarity

Please keep in mind that, in this simple example, we have not considered the trading fees the LP Token would have earned the investor. Popular protocols, like Uniswap, charge 0.03% on every trade executed in a liquidity pool. Many others follow this rate, but newer projects may charge lower fees to attract users to the platform.

Popular platforms with high trading volume can see very high trading fees. This can be profitable to liquidity providers.

We have also not considered additional steps the investor could take to earn other assets with their LP Tokens, like Liquidity Mining or Yield Farming.

For more seasoned DeFi readers, we suggest reading these articles for additional learning:

• Uniswap: A Good Deal for Liquidity Providers? (by Pintail)
• Impermanent Loss Explained with Examples & Math (by Chain Bulletin’s Doncho Karaivanov)

Find Liquidity Pools with a Stablecoin Pairing

For risk-averse DeFi investors, providing liquidity pools with stablecoin assets offers a safer approach as the price of stablecoins tends to remain consistently around $1USD. In this scenario, a liquidity provider (LP) would find more value in earning trading fees from being an LP than investing those stablecoins in other tokenized assets.

This can be a widely used investment strategy during a bear market, when asset prices are usually in a macro downtrend.

Curve (https://curve.fi/) is a popular DeFi protocol with stablecoin pools.

Source Liquidity Pools with High Volume and/or Trading Fees

When users interact with the liquidity pool, they pay a small trading fee for their exchange. Liquidity providers earn an amount of the trading fees proportionate to the number of LP Tokens they hold. Depending on market conditions and other factors, these trading fees may justify the risk of impermanent loss. The impact of impermanent loss is reduced as the trading fees accumulate over time.

Popular DeFi protocols, like Uniswap, Curve, etc., have more trading activity, which can be attractive to liquidity providers.

Single-Sided Staking Pools

Some DeFi products offer liquidity providers the ability to add a single asset to a pool. In these scenarios, there’s no risk of impermanent loss.

DeFi Protocols with Flexible Asset Ratios

There are a few DeFi protocols, like Balancer (https://balancer.fi/), who offer the ability for liquidity providers to provide assets with ratios that are not the traditional 50/50. For example, a Balancer pool may offer an 80/20 or 95/5 ratio. In this case, assuming the asset with the 95% ratio is stable, the impacts of impermanent loss are significantly reduced to that of the 50/50 pool.

Include Yield Farming in Your Overall Strategy

For more experienced DeFi users, Yield Farming can provide an extra way to earn assets with their LP Tokens. By adding their LP Tokens to a yield farm, users can earn additional tokens (typically, a DeFi protocols native token) to accumulate more returns. This, however, adds another layer of risk as the investor must interact with another smart contract.

Impermanent Loss Protection

As the name implies, some protocols cover the costs of impermanent loss themselves. For example, when a user makes a deposit on Bancor, “insurance coverage” provided by the protocol grows at a rate of 1% per day; reaching full coverage after 100 days. Impermanent loss experienced by an investor after that period is repaid at the time of withdrawal.

Update: Bancor has reportedly suspended this offering, per Blockworks report.

Keep in mind that, in a general sense, the pricing activity and pool-ratio balancing done within a DeFi protocol is managed by the algorithm that focuses on its own pool.

If/when a DeFi protocol integrates and Oracle, extensive price data is pulled from many different external sources: DEXs, CEXs, etc. This data supports the algorithm by giving it information on the pool’s asset performance from other sources. The algorithm can manage the balancing of the pools more efficiently and effectively, instead of relying solely on the activity of its own pool. More active and data-driven pool management can help liquidity providers avoid more dramatic impermanent loss results.