Summary

If you have participated in DeFi projects, you must have heard of this term. Impermanent losses occur when the price of the token held changes compared to when it was deposited into the pool. The larger the price difference, the greater the impermanent loss.

What? Will you still lose money if you provide liquidity? Why is it said that this kind of loss is impermanent? In fact, it comes from the inherent design characteristics of a special market-automated market makers. Providing liquidity to liquidity pools is indeed profitable, but one must always be aware of the concept of "impermanent loss".

Introduction

The trading volume and liquidity of DeFi protocols such as Uniswap, SushiSwap or PancakeSwap have exploded increase. With these liquidity protocols, any fund holder can become a market maker and earn trading fees. The democratized market-making mechanism makes many economic activities in the digital currency field more harmonious.

So, what do you need to know before providing liquidity to these platforms? In this article, we will discuss one of the most important concepts - impermanent loss.

What is an impermanent loss?

Providing liquidity to a liquidity pool may produce impermanent losses. At this time, the price of the deposited asset will change compared to the time of deposit. The greater the change, the higher the probability of suffering impermanent losses. In this case, an impermanent loss means that the dollar value at the time of withdrawal is less than the value of the deposit.

If the price of the assets in the pool is within a relatively small range of changes, the risk of suffering impermanent losses will be reduced. For example, a stablecoin or different pegged versions of a token will be within a relatively stable price range. In this case, the liquidity provider (LP) is less exposed to impermanent losses.

Why do liquidity providers still provide liquidity when they know that they may suffer impermanent losses? In fact, impermanent losses can be offset by transaction fees. In fact, even in capital pools like Uniswap, which are prone to unpredictable losses, users can still profit from transaction fees.

Uniswap charges a 0.3% handling fee for each transaction conducted directly with a liquidity provider. If the trading volume of a given pool is extremely high, it can still be profitable to provide liquidity to it even in the face of huge impermanent losses. However, this depends on the protocol, the specific pool, the assets deposited, and even numerous market environment factors.

How does impermanent loss arise?

Let us use a case to illustrate how the impermanent losses suffered by liquidity providers arise.

Alice deposited 1 ETH and 100 DAI in the liquidity pool. In this special automated market maker (AMM) mechanism, the deposited token pair needs to consist of two tokens of equal value. This means that when depositing the token, the price of 1 ETH is equal to 100 DAI. At this point, Alice's assets were worth $200 at the time of deposit.

In addition, there are a total of 10 ETH and 1,000 DAI in the fund pool (the remaining funds are provided by the same liquidity provider as Alice). Therefore, Alice has a 10% share in the fund pool and the total liquidity is 10,000.

Suppose the price of ETH rises to 400 DAI. In this case, arbitrage traders pour DAI into the pool and remove ETH until the ratio reflects the current price. Please note that the automated market maker mechanism does not use order books. The factor that determines the price of the assets in the pool is the proportion of different assets in the pool . While overall liquidity remains the same (i.e. 10,000), the ratio of assets in the pool changes.

If the price of ETH becomes 400 DAI, the ratio of these two tokens in the fund pool will change accordingly. Due to the actions of arbitrage traders, there are currently 5 ETH and 2,000 DAI in the pool.

If Alice decides to withdraw her funds, as we previously knew, she is entitled to 10% of the pool. Therefore, 0.5 ETH and 200 DAI can be withdrawn, for a total value of $400. Compared to the $200 she deposited, she undoubtedly made a substantial profit. However, what happens if you hold 1 ETH and 100 DAI all the time? The total value of these assets will rise to $500.

The results show that Alice can earn higher returns by holding these assets than depositing them in the liquidity pool. This is the so-called "impermanent loss". In the above case, Alice's losses were minimal and her initial deposit amount was relatively small. However, it is important to note that impermanent losses can trigger significant losses (even including a large portion of the initial deposit).

Having said that, this case completely ignores the transaction fees that Alice earns by providing liquidity. In many cases, the fees earned can offset the losses and the liquidity provider still earns a profit. Even so, it’s important to understand the important concept of impermanent loss before providing liquidity to a DeFi protocol.

Impermanent loss estimation

When the price of the assets in the pool changes, impermanent losses will occur. How is the specific amount of loss calculated? We can plot this in a graph. Please note that this chart does not take into account trading fees earned by providing liquidity.

Through this chart, we can understand the losses caused by price changes compared with simply holding coins:

• 1.25 times spread = loss of 0.6%
• 1.50 times spread = loss of 2.0%
• 1.75 times spread = loss of 3.8%
• 2 times the spread = loss of 5.7%
• 3 times the spread = loss of 13.4%
• 4 times the spread = loss of 20.0%
• 5 times the spread = loss of 25.5%

There are also some important things you need to know. No matter how the spread develops, impermanent losses will occur. Impermanent losses exist as long as the price changes compared to when the deposit was made. If you want to learn more about this, check out Pintail’s article.

Risk of providing liquidity to automated market makers

In fact, the statement "impermanent loss" does not Not relevant. The reason for this name is that losses will not materialize until the tokens are withdrawn from the liquidity pool. From that point on, impermanent losses largely transform into permanent losses. The trading fees you earn may cover such losses, but the name is a bit misleading.

Extra care needs to be taken when providing liquidity to automated market makers (AMMs). As discussed above, some liquidity pools are more susceptible to impermanent losses than others. Simply put, the greater the volatility of the assets in the pool, the higher the probability of suffering impermanent losses. At the beginning, we recommend depositing only a small amount of money. This way, you can take it step by step and get a rough estimate of expected returns before investing more money.

The final point is to look for more proven automated market makers. DeFi projects allow any participant to easily fork existing automated market makers and add some minor changes. However, this could leave you open to serious mistakes that could leave your funds stuck with the automated market maker forever. If the return rate promised by a certain liquidity pool is unusually high, then there may be certain drawbacks somewhere else, and the corresponding risks will be higher.

➟ Want to start a digital currency journey? Welcome to buy Bitcoin (BTC) on Binance!

Summary

Impermanent losses are what all wish to offer automated market makers (AMMs) Mobility is one of the basic concepts that everyone should understand. Simply put, if the price of the deposited asset changes compared to the time of deposit, the liquidity provider may suffer impermanent losses.

Do you have any other questions about impermanent losses or sliding spreads? Please visit our Q&A platform Ask Academy, where members of the Binance community will patiently answer your questions.