Impermanent Loss guide For DeFi Users

Complete Impermanent Loss guide For DeFi Users – ‘Impermanent Loss’ is a sort of a risk that involves providing Liquidity dual capital pools in DeFi Protocols. The difference in value between depositing 2 crypto assets in a liquidity pool based on Automated Market Maker (AMM) or simply holding them in a crypto wallet. Most importantly, it happens when depositing them in an AMM and then withdrawing them later on a loss. If you would have left them in your wallet, you may not lose any money. 

However, your profits would be less relative if you had just simply your cryptos untouched. Conversely, losses may be multiplied depending on the moves in the market. The phenomenon earns its name as any Loss can only be realized once the funds have been withdrawn. Until then, if there is any loss present only on paper, it may reduce and completely disappear depending on how the market moves. Here is a simplified example of impermanent Loss:

Providing Liquidity

Held in Wallet

Day – 1 (Deposited)

Value of Asset Pair – $200

Value of Asset Pair – $200

Day – 2 (Withdrawn)

Value of Asset Pair – $270

Value of Asset Pair – $300

How Impermanent Loss Occurs

When you provide Liquidity to a particular pool, you deposit the assets in equal values like $100 of DAI & $100 of Ethereum. Then, you receive LP Tokens (Liquidity Provider Tokens) to prove a certain percentage of ownership in the Pool. So, if you have deposited $200 worth of funds in the Pool bringing out a total of $1000, your LP tokens will represent your share to be 20%. 

However, if other people add on some assets in the Pool, your share of assets will reduce to 10% in the Pool. Unfortunately, there is a risk involved; when you provide 2 assets in a single pool, it needs the value of the assets to be equal. As the value of one of them or both of them starts to fluctuate, the Pool’s balance also shifts. If the depositors constantly trade-in & out of the Pool, it may also imbalance the Pool as its one side may grow or contract. 

It will further end up something like – 60/40 balance. When this situation occurs, it creates an opportunity for commercial traders to purchase an asset at a discounted rate. By taking this advantage, commercial traders naturally rebalance the Pool. It is an essential part of how AMM operates but generates a problem for the providers of liquidity providers. Due to this imbalance, the no. of tokens on either side will shift even if their value remains the same. 

It would help if you also remembered that LP tokens entitle you to a certain percentage in the Pool than an amount of assets equivalent. This further means that you may receive one extra token or another token lesser when you withdraw your funds from the Pool. Moreover, depending on how the assets fluctuate in their prices, you may have to face losses compared to if you had just left them in your wallet.

How To Calculate Impermanent Loss?

If you (David) are a crypto investor & have some investment in BNB tokens, it is an excellent idea to hold these tokens for a month. However, if you are confused about whether you should hold these tokens in your wallet or deposit them in a liquidity fund, let us try to help you out.

Option – 1: Depositing Your Assets in a BNB/USDT Pool on Uniswap

Just suppose you have 10 BNB Tokens, which you can deposit in the Pool. To deposit 10 BNB Tokens in the BNB/USDT pool when the value of a single BNB is 400 USDT, you will also need to deposit 4000 USDT. Thus, you will have to deposit total assets of $8000.

Option – 2: You Keep All The Assets With Yourself & HODL

For now, focus on option – 1. Suppose after a month of depositing the funds, the price of BNB elevates by 25 percent to USDT 500 in the market. The rates on Uniswap would remain USDT as that is not affected by the market. This Price Inefficiency will generate an opportunity for arbitrage profit till the time rates on BNB on Uniswap Uniswap are equivalent to the remaining of the market. 

This means that arbitrageurs will buy cheaper BNB from Uniswap and further sell it on Binance. This will keep altering the ratio of the assets in the Pool till the BNB price is 500 USDT. After this, the ratio of USDT & BNB in the liquidity pool would have changed. So when you withdraw your assets, the assets’ ratio withdrawn will be dissimilar to the ratio you deposited.

Caution – Uniswap will allow you to trade ERC-20 tokens only. We have taken the example of BNB just to clarify the topic to you.

For instance, when you withdraw your funds, you’ll receive 8.75 BNB & 4375 USDT. So, in option 1, you’ll deposit assets of $8000, and in option 2, you’ll receive the assets with a value of $6750 for 1 month. Please note that you can calculate the assets that you’ll receive while withdrawing with the help of the Impermanent Loss Calculator.

Let’s now compare this with option -2, i.e., what would have been the possible value of the assets if you would have handled it.

So, you had assets with a value of $8000 as the starting investment. In option – 1, when you withdraw funds from liquidity funds, you have funds with a value of $8750. Nevertheless, when you simply HODL, you would have the assets with a value of $9000. This means you have faced an Impermanent Loss of $250 ($9000 – $8750).

It is worth considering that impermanent Loss happens not only due to an elevation in the price but also due to a reduction in the price. Therefore, the more the percent gap increases in the price, the more imminent the impermanent Loss will be. That is why the risk of impermanent Loss is significantly lesser if both the assets settled in the pools are stablecoins.

Does This Mean That We Should not Provide Liquidity to the Pool?

A decentralized Exchange Platform shares a portion of the trading fee of the platform with the liquidity provider. In the majority of the cases, the trading fee given by the liquidity provider from the exchange is something more than impermanent Loss.

Furthermore, these exchanges also reward in-house tokens to the liquidity providers through liquidity mining. Therefore, a liquidity provider always needs to be in a good situation. That’s why in the example mentioned above, the share of trading fee that you received would have been greater than your loss. That’s why you would ultimately have gained by offering Liquidity to the DEX. But whatsoever, it would be great to contemplate the risk of Loss before providing the liquidity funds to the DEX.

Possible Scenarios of Impermanent Loss/Profit

AMM (Automated Market Maker) is a technology that makes DeFi an open & decentralized ecosystem. AMM basically makes it possible for you to exchange digital assets such as DAI for ETH without interacting with ‘Centralized Service Providers’. In opposition to traditional exchange systems like Coinbase, Binance, & CEX, AMM is simply a set of smart contracts and is based on distributed ledgers. In contrast to centralized counterparties, AMM doesn’t suffer from any regulations, censorship, or pressure on token buyers’ & sellers’ privacy.

With this introduction of AMM, now let’s move on and get to know about ‘Impermanent Loss’. Necessarily, one can define an Impermanent Loss as the loss of funds during liquidity provision. As a simplified explanation, you may consider it as a difference between the reserves that a trader has in AMMs Versus Funds in the wallet. Usually, Impermanent Loss happens in standard Liquidity Pools where the liquidity providers are obligated to keep both the assets in an accurate ratio.

But if the tokens’ price volatile & diverge in such a direction that will increase the difference in the ratio will further increase the impermanent loss. Let’s now consider an example Uniswap DAI/ETH as a 50/50 Liquidity Pool. If a token will go up or another will go down, the pool will fully rely on an uninterrupted arbitrageur to ensure the reflection of the real price of the ratio to balance back the value of both the tokens.

To understand more deeply about the occurrence of Impermanent Loss, let’s now review an example of token pair of DAI/ETH on the Uniswap Pool. Let us consider a liquidity supply of 50/50 in the pool. To achieve it, the liquidity provider will have to make sure that he keeps an equal value for DAI as well as ETH.

In this case, the ETH’s price goes up and reaches $550 on Coinbase for 1 ETH Token. It’s exactly the same spot when investments gets triggered. Differences in prices on Coinbase & Uniswap is a great opportunity to make a big profit for arbitrage. Uniswap uses AMM to balance the ratio of tokens in the pool. Therefore, when ETH is continuously bought from the pool, its price goes higher & higher. Obviously, this will continue until the ETH’s price will stabilize between the exchanges.

How Do I Avoid Impermanent Loss?

Here are a few ways of avoiding impermanent Loss:

1. Offering your liquidity funds to a more stable pair of coins.
2. Avoid volatile & risky crypto pairs.
3. Depositing your Liquidity in a pool with an unequal ratio of cryptocurrencies.
4. Providing your Liquidity in a more motivated pool.
5. Regularly participating in various Liquidity Mining Programs.

Is Providing Your Liquidity To A Pool Worth It?

That actually depends on your investment horizon as well as the crypto pairs on which you are offering your Liquidity. In some of the scenarios, it could be even better HODLing. However, in some scenarios, impermanent Loss may eat up your profit.

Wrapping Up

Impermanent loss occurs when a pool consisting of any volatile asset and the value of those assets is set. Various protocols like Curve & Balancer have put efforts to solve the impermanent Loss by generating variable weights. However, whatsoever, they are only able to diminish this risk to some extent. On the other side, Bancor has managed to create changing weights that are impacted by those assets’ prices.

These prices are linked in the chain with the assistance of Chainlink Oracle & Voila! As a result, the risk factor of Impermanent Loss is entirely mitigated. However, still, many platforms reveal their liquidity providers to a risk of impermanent Loss. That is why each & every liquidity provider should know this risk factor before putting in their valuable assets in any Liquidity Pool.