Markets such as Uniswap, SushiSwap, and PancakeSwap have experienced an increase in volume and liquidity thanks to DeFi protocols.
Anyone with money can become a market maker and earn trading fees using these liquidity protocols. As a result, democratizing market making has enabled a lot of frictionless economic activity in the crypto world.
In this post, we’ll talk about one of the most critical things to understand if you want to provide liquidity for these platforms: impermanent loss.
What is an impermanent loss?
When you deposit assets into a liquidity pool, you are providing liquidity.
When the price of your deposited assets changes relative to when you deposited them, you are exposed to impermanent loss. You suffer a monetary loss when you withdraw less dollars than you deposit.
Stablecoins or wrapped versions of a coin, for example, will remain in a relatively limited price range. This minimizes the risk of impermanent loss for liquidity providers (LPs).
Even though liquidity providers are exposed to impermanent losses, they still provide liquidity because even pools on Uniswap that are quite exposed to impermanent loss can be profitable thanks to trading fees.
There is no charge to use Uniswap, but if there is a lot of trading volume in a pool, it can be profitable to provide liquidity even if the pool is heavily exposed to impermanent loss.
This, however, depends on the protocol, the specific pool, the deposited assets, and even broader market conditions.
So what causes impermanent loss?
Watching the following video by Whiteboard Crypto is a good starting point:
Here’s a more concrete example:
When depositing 1 ETH and 100 DAI in a particular automated market maker (AMM), the token pair must have the same value. This indicates that the price of ETH is 100 DAI at the time of deposit. In addition, the dollar value of Alice’s deposit is 200 USD at the time of deposit.
Furthermore, there is a pool of 10 ETH and 1,000 DAI that has been funded by other LPs like Alice. Because of this, Alice owns a 10% share of the pool, which has a total liquidity of 10,000 ETH and 1,000 DAI.
First off, let’s assume that ETH’s price rises to 400 DAI. Arbitrage traders will withdraw DAI from the pool until the ratio reflects the current price. Since AMMs lack order books, the price of the assets in the pool is based on their proportion. As the pool liquidates (10,000), the proportions of the assets change.
The amount of ETH and DAI in the pool have changed relative to one another if ETH is now 400 DAI. Thanks to arbitrage traders, there are now 5 ETH and 2,000 DAI in the pool.
We’ve learned from earlier that Alice is entitled to a 10% share of the fund. Since she has withdrawn her funds, she may withdraw 0.5 ETH and 200 DAI, for a sum of 400 USD. Since she deposited tokens worth 200 USD, she made some good profits, right?
However, what would happen if she simply held her Ethereum and Dai? The total value of the tokens would be 500 USD now.
Looking at the picture, we can see that Alice would have been better off if she had HODLed rather than deposited her tokens into the liquidity pool. This is what we call impermanent loss.
Although the initial deposit was relatively small, Alice’s loss was not substantial. Remember, however, that impermanent loss can result in major losses (including a big portion of the original deposit).
Despite all of the drawbacks outlined above, Alice’s example completely overlooks the fact that she would have earned money by providing liquidity. In many situations, the fees earned would offset the losses and turn providing liquidity profitable. It is critical to bear in mind, however, that providing liquidity to a DeFi protocol is a permanent loss.
The potential risks of providing liquidity to an AMM
The unfortunate moniker of impermanent loss is rather misleading. The losses are only realised once you withdraw your coins from the liquidity pool, but once you do, they become permanent.
Even if you earn fees, it’s still slightly misleading.
When you deposit funds into an AMM, be extra vigilant. As we have discussed, some liquidity pools are more susceptible to temporary losses than others.
If you deposit into a pool with volatile assets, you may experience temporary losses. It can also be a better idea to deposit a small amount initially. That way, you can get an idea of what you can expect in return before committing a large amount.
You should also look for more reliable DeFi AMMs. It’s quite simple for anyone to fork an existing AMM and make minor alterations. This, however, may expose you to bugs, leaving you with a stuck AMM forever.
If a liquidity pool promises unusually high returns, there’s most likely a downside somewhere, and the risks are probably also higher.
6 Ways to avoid impermanent loss
There are several ways to avoid impermanent loss, however:
Final thoughts
A LP who wishes to provide liquidity to AMMs should be familiar with the concept of impermanent loss. To put it simply, if the price of the deposited asset changes after the deposit, the LP may be exposed to impermanent loss.
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