Impermanent Loss explained

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Impermanent loss refers to a temporary loss caused to a liquidity provider due to the volatility in a trading pair.

With the growing popularity of Decentralized Finance (DeFi) platforms, we have witnessed an increase in usage of platforms like Uniswap, SushiSwap, or PancakeSwap. These liquidity protocols enable essentially anyone with funds to become a market maker and earn trading fees.

However, there is one fundamental issue with Automated Market Maker (AMM) platforms: users providing liquidity stand a risk of losing their staked funds for simply holding on to them.

In that case, the loss means less dollar value at the time of withdrawal than at the time of deposit.

In this article, Liquid has discussed everything you need to know about the concept of impermanent loss.

What is Impermanent loss?

Impermanent losses are one of the risks concerned with Liquidity Pools in DeFi.

It refers to the difference in value between funds held in an AMM and funds held in your wallet. Impermanent loss occurs when the value of the funds staked to the AMM fluctuates drastically.

The more significant the price fluctuations is, the greater the impermanent loss can be.

These price fluctuations essentially result in a temporary loss of funds because of volatility in a trading pair.

Impermanent loss often seems to scare institutional investors away from providing liquidity to liquidity pools.

Why do impermanent losses occur?

Since automated market maker platforms are disconnected from external markets, changes to the token price on external markets will not affect prices on the AMM.

For prices to change on AMM, arbiters need to purchase the unpriced asset or sell the overpriced asset offered by the AMM. While it happens, arbiters will churn out profits, resulting in an impermanent loss.

So, why and how impermanent loss occurs? Let’s consider one example.

Let's say you have two types of assets (DAI/ETH pool) staked on an AMM. If the value of ETH jumps by 10 percent, it will create an arbitrage opportunity for traders. Arbiters can purchase ETH from the AMM at 10 percent cheaper prices than external markets. Arbiters will then be incentivized for selling equivalent DAI balancing the AMM.

As a result, liquidity providers will suffer from impermanent loss for holding on to both ETH and DAI.

Why is it called ‘Impermanent loss?’

The meaning of the word ‘impermanent’ is temporary or not permanent. Meaning, the loss of funds to the liquidity provider is temporary and not permanent. So, does that mean there is a way to get your money back? Well, yes!

How to recover from Impermanent loss?

There is one way you can get your money back:

If the price of the token staked to AMM returns to the original price (when you first staked your funds to the AMM), you can get your money back. If that happens, you are already out of impermanent loss, and you can earn 100 percent of your trading fees. However, this a very rare possibility, and more often than not, chances are you might lose your funds permanently.

How to minimize impermanent losses?

One way you can protect yourself and minimize your losses is through stablecoins.

Liquidity Pools providing liquidity through stablecoins locked in a smart contract are less volatile, essentially helping reduce the risk of impermanent losses.

Another way you can reduce the risk of impermanent losses is by joining pools that offer arbitrary weights.

Many liquidity pools provide users with an option to deposit two assets in 50/50, 80/20, or 98/2 ratio to reduce the impact of impermanent losses.

Conclusion

Before you dive deep into the DeFi world, ensure that you do your research and be prepared for the risks involved. Providing liquidity to a liquidity pool can be a profitable venture, but you’ll need to keep the concept of impermanent loss in mind.

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