📉Dive into the Pool #3: What is Impermanent Loss (IL)? (2024)

Welcome back to Dive into the Pool! Your weekly meeting to understand DeFi!

From our latest survey, we understand that many of you are keen to learn about impermanent loss (IL), a common concern among liquidity providers in the DeFi space. If you’re new to DeFi or have experienced reduced returns from liquidity providing, this article is for you. Here, we’ll demystify impermanent loss and explore how it can impact your yield. 😉

Before we dive in, if you’re not yet familiar with liquidity pools and Automated Market Makers (AMMs), we recommend reading our previous articles on these topics, as they lay the foundation for understanding impermanent loss.

All set? Let’s dive in!

What is Impermanent Loss? 📉

Impermanent loss occurs when the price of assets deposited in a liquidity pool changes from the time they were deposited. This creates a difference in value compared to holding them outside the pool. Basically, it’s the potential loss you face in a liquidity pool due to volatility in asset prices.

The loss is “impermanent” because if the price of your assets goes back to its initial price, you won’t suffer impermanent loss. On the other hand, if you withdraw your funds from the liquidity pool when the price of your deposited assets have changed, your loss will become permanent.

Liquidity pools, being independent from each other and from centralized exchanges (CEXs), often have different asset prices creating opportunities for traders. If an asset’s price in a pool differs from its market price, traders can profit by buying the asset in the pool and selling it elsewhere.

Feeling lost?🧐 Don’t worry, it is easier to understand with an example.

Practical Example :

Note: This example does not account for the yield fees generated by providing liquidity.

Imagine you’ve provided 0.5 ETH and 500 USDC (total value = $1000) in a 50/50 ETH/USDC liquidity pool. At the time of your deposit, 1 ETH equals $1000 in the pool, but it’s $1100 on Binance. A trader will seize this opportunity to buy ETH in the liquidity pool and sell it on Binance to make a profit.

Using the constant product market maker formula (x * y = k), where X and Y are the amounts of each token, and K is a constant (if you’re not familiar with this concept, check our article about AMMs here), we can calculate the new balance after arbitrage, don’t worry I’ll spare you the maths.

After the trade, your share is 0.477 ETH and 524.404 USDC, totaling $1048.8. The swap that occurred adjusts the supply of tokens available in the pool, affecting your share. You could say, great I made a profit anyway, but if you had kept your assets outside the pool, you’d have 0.5 ETH ($550) and 500 USDC, totaling $1050. The $1.2 difference is the impermanent loss.

Note : This move of benefiting from price differences between two platforms to generate profit is called arbitrage. It is a mechanism very useful to the ecosystem — We can make an article on this topic if you’d like!

Now let’s see how we can reduce impermanent loss.

Strategies to mitigate Impermanent Loss 🤺

If you have done liquidity providing, you now understand why your returns were lower than you might have thought.

As you may have noticed, the IL comes when the two assets that you have deposited in the pool are not correlated.

Here are 3 ways to reduce the IL :

1. Stablecoin Pairs: Use pools composed of stablecoin pairs. Since their value is pegged and volatility is minimal, the risk of impermanent loss is significantly reduced, if not entirely eliminated.
2. Correlated Asset Pairs: Choose pools with correlated assets. When the assets’ prices move in tandem, the relative price remains stable, reducing the likelihood of impermanent loss.
3. Use Lobster 😉

The Lobster Solution 🦞

Lobster allows users to benefit from liquidity providing without having to worry about impermanent loss.

By predicting it with our algorithms, we are able to take it in consideration and reduce it when calculating and generating your interests. The APY that you’ll see on our platform accounts already impermanent loss. Lobster is the best way to generate yield without the need to constantly monitor your DeFi positions.

You can sleep soundly with Lobster by your side 😴