What is Impermanent Loss?
Impermanent loss is a financial risk that can occur when an investor provides liquidity to an automated market maker (AMM) platform in a decentralized finance (DeFi) ecosystem. This type of risk is caused by price changes in the crypto market and the way automated market makers (AMMs) are designed.
AMMs are decentralized exchanges (DEXs) that enable users to trade digital assets without relying on a centralized intermediary or traditional order book. DEX liquidity pools require investors to lock in two different types of tokens as a pair, and the value of the invested token pair is expressed as a ratio.
When token prices change, the ratio is automatically adjusted to ensure the pool’s total value remains constant during trades. As long as the ratio stays the same as it was when the tokens were initially invested, the potential for loss is eliminated. The problem is that this hardly ever happens because of the volatile nature of cryptocurrency markets.
How Impermanent Loss Works
Imagine that someone named Alex contributes a token pair to a liquidity pool in order to earn some passive income. In this example, let’s call their tokens Token A and Token B.
Now imagine that over time, the price of Token A increases significantly more than the price of Token B. If Alex decides to withdraw their tokens from the pool at this point, they’ll receive fewer Token A and more Token B than they initially contributed.
The difference in value between what Alex originally put in and what they could potentially receive back is called impermanent loss. The loss is considered impermanent because as long as Alex keeps their tokens in the pool, they won’t experience an actual loss.
The risk of an actual loss can be offset if Alex waits until the price ratio returns to the initial exchange rate – or if they invest in pools with high trading volumes so their losses can be compensated by trading fees or other investment rewards.
Calculating Impermanent Loss
To calculate impermanent loss and forecast the potential for permanent loss, investors first need to calculate the relative value by dividing the current value of invested assets by the initial value of the same assets.
Then, they can compare the relative value to the external market returns. The difference between these two values will provide the average investor with a rough idea of the potential loss.
Here is an example of how this would work:
Let’s say that Alex contributes $1,000 worth of Token A and $1,000 worth of Token B to a liquidity pool. Initially, the total value of their assets is $2,000.
Over time, let’s imagine that the price of Token A doubles, while the price of Token B remains the same. The return on investment (ROI) for Token A would be 100% (because it doubled in value), while the ROI for Token B would be 0% (because the value remained the same).
Now Alex has $2,000 worth of Token A and $1,000 worth of Token B. At this point in time, her assets are worth $3,000 ($2,000 + $1,000) and the average external market return for both tokens is 50% (the average of 100% and 0%).
To find the relative value of their invested assets, Alex needs to check the current value of her assets in the liquidity pool. They can calculate the relative value by dividing the current value of her assets ($3,000) by the initial value of her assets ($2,000). In this example, the relative value of Alex’s investments is 1.5 or 150%.
Finally, Alex needs to compare the relative value (150%) to the average external market return (50%). The difference between the two values is 100% (150 – 50) which means that the impermanent loss for this investment is 100%.
Unfortunately, this means that the potential for permanent loss is also 100% if Alex withdraws their tokens at the wrong time. Even worse, this also means that the value of Alex’s assets would have increased by 100% if they kept the tokens in their wallet instead of investing them in a liquidity pool.
The complexity of calculating impermanent loss is a significant problem for DeFi platforms that rely on liquidity providers (LPs) to keep their platforms operational because the mathematical probability of impermanent loss happens no matter which direction token prices change.
To minimize the risk of investing in liquidity pools and attract investors, DEXs have created investment incentives like yield farming.
Yield farming allows investors to participate in multiple liquidity pools at the same time. This strategy is intended to reduce the impact of any single pool’s losses by spreading risk across multiple pools.
Other strategies for reducing the risk of investing in liquidity pools include the following:
- Regularly calculate impermanent loss to make informed decisions about when to enter or exit a pool.
- Look for pools with high trading volume so trading fees can help offset potential losses.
- Avoid pools with volatile token pairs and seek out pools that feature stablecoins.
- Seek out platforms that offer full protection from impermanent loss.