c Beginner's Guide to Impermanent Loss - Digital Stade

Beginner's Guide to Impermanent Loss

Beginner's Guide to Impermanent Loss

Decentralized finance (DeFi) has opened up a world of possibilities for cryptocurrency investors to earn interest in their holdings.

By decentralising traditional financial services, anyone can now lend funds to DeFi applications. Depositing digital assets, often into standard liquidity pools, can earn investors' interest rates far above what global banks are currently offering.

However, while high-interest rates are offered as a potential upside, liquidity pools offer a sometimes unknown downside risk known as getting rekt (impermanent loss).

In this guide, I will explain exactly what getting rekt is, provide an easy follow example and outline the steps investors can implement to mitigate the risk.

 

What Is Impermanent Loss?

Impermanent loss describes the temporary loss of funds occasionally experienced by liquidity providers because of volatility in a trading pair. This also illustrates how much more money someone would have had if they simply held onto their assets instead of providing liquidity.

Liquidity pools often feature two assets — and while one might be a stable coin such as DAI, the other could be a more volatile cryptocurrency, such as ETH.

Let’s imagine that a provider (A liquidity provider is a user who funds a liquidity pool with crypto assets she owns to facilitate trading on the platform and earn passive income on her deposit) needs to offer equal levels of liquidity in both DAI and ETH — but suddenly, the price of ETH goes up.

This creates an irresistible opportunity for arbitrage because the price of ETH in the liquidity pool (Liquidity pools are pools of tokens locked in smart contracts that provide liquidity in decentralized exchanges in an attempt to attenuate the problems caused by the illiquidity typical of such systems) now doesn’t reflect what’s going on in the real world. To ensure the ratio of DAI to ETH remains balanced, other traders will buy ETH at a discounted rate until there’s equilibrium again.

After arbitrage, a liquidity provider may end up with a greater amount of DAI and slightly less ETH. Impairment loss assesses the current value of their assets against what they would be worth if left sitting pretty in an exchange.

The loss only becomes permanent if a provider withdraws its liquidity for good.

 

How Does Impermanent Loss Occur?

To understand how impermanent loss occurs, we first need to understand how AMM (An automated market maker (AMM) is a system that provides liquidity to the exchange it operates in through automated trading.) pricing works and the role arbitrageurs play.

In their raw form, AMMs are disconnected from external markets. If token prices change in external markets, and AMM doesn’t automatically adjust its prices. It requires an arbitrageur to come along and buy the underpriced asset or sell the overpriced asset until prices offered by the AMM match external markets.

During this process, it effectively removed the profit extracted by arbitrageurs from the pockets of liquidity providers, resulting in an impermanent loss.

For example, consider an AMM with two assets, ETH and DAI, set at a 50/50 ratio. As shown below, a change in the price of ETH opens an opportunity for arbitrageurs to profit at the expense of liquidity providers.

impermanent-loss-calculation

If you examine different price movements, you can see that even small changes in the price of ETH cause liquidity providers to suffer impermanent loss:

impermanent-loss-from-eth

Clearly, this is an issue that needs to be addressed if AMMs are to achieve widespread adoption among everyday users and institutions.

I expect if users constantly monitor and act on changes in the AMM to avoid significant losses, liquidity provision becomes a game that is reserved for only the most advanced traders (see: traditional finance).

Rather than designing second-layer tools to monitor and manage AMM risk, why not try to mitigate impermanent loss at the protocol level?

 

How To Avoid Impermanent Loss

In a volatile marketplace, impermanent loss is almost guaranteed when staking cryptocurrency assets within a standard liquidity pool. Exchange prices are always going to move. However, there are ways that the effects of impermanent loss can be mitigated.

 

Low volatility pairs

Impermanent loss is likely to occur for most volatile cryptocurrency pairings. However, impermanent loss can be mitigated by choosing a cryptocurrency pairing where the exchange price is not volatile. Examples of low volatility pairs include stablecoin pairings such as DAI:USDT, or different variations of the same token such as wETH(wrapped Ether):ETH. These examples include cryptocurrency pairings that follow a very similar price. Therefore, significant price movements between the pair are unlikely. If price volatility does not exist, impermanent loss can be avoided.

 

Trading fees

In the above math example, no trading fees were added to the liquidity pool. Trading fees are collected from traders using the liquidity pool and a share of those fees are then rewarded to liquidity providers. These fees are sometimes enough to mitigate and offset any impermanent loss. The more trading fees collected, the less impermanent loss there will be. Past a certain point, if a pool collects enough fees an investor will have gained more from staking assets in a liquidity pool compared with holding them.

 

Complex liquidity pools

One of the main reasons for impermanent loss is due to the 50:50 split that is required by most liquidity pools. To overcome this issue, some decentralized exchanges such as Balancer offer users a variety of liquidity pool ratios. They also offer pools with more than 2 digital assets. Price changes in pools that have a higher ratio, such as 80:20 or 98:2, do not result in as much impermanent loss when compared with pools that have a 50:50 split.

 

Conclusion

While the basics of impermanent loss have been covered, there are a couple of extra details that are worth knowing before staking liquidity in DeFi protocols.

Impermanent loss can occur regardless of price direction. In the math example above, we increased the price of ETH and explained that impermanent loss meant gains were lessened compared to digital assets sitting in a wallet. However, impermanent loss occurs regardless of which asset in the cryptocurrency pair is moving. An investor can only withdraw digital assets that have not suffered an impermanent loss if the exchange price is exactly the same at the time of withdrawal.

Second, an impermanent loss is only realised when funds are withdrawn. It is "impermanent" because prices could return to the initial exchange price. If prices returned, the impermanent loss would no longer exist. The loss is only permanent if an investor withdraws their funds from the liquidity pool.

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