Jan 6, 2023 | Updated Jul 18, 2023
Impermanent loss is a risk that occurs when participating in DeFi liquidity pools. It happens when the price of your deposited assets change from the time you deposited them.What is Impermanent Loss in Crypto?
It refers to a situation in which the profit you gain from staking a token in a liquidity pool is less than what you would have earned just holding the asset. It happens when a token’s price changes in the market, which causes your deposited assets in the liquidity pool to become worth less than their present value in the market. The bigger this price change, the more your assets are exposed to impermanent loss.
For example, if the value of the assets in the pool decreases by 10%, but the value of the LP tokens only decreases by 5%, the user will have incurred a 5% impermanent loss.
It indicates how much more the value of your assets would be if you just HODL instead of providing liquidity. This gap is “impermanent” because it is possible to close the gap if the token price returns to the former price. It’s also important to note that impermanent loss does not take into account trading fees that investors earn for providing liquidity, which in many cases can negate any losses.
How Does It Work?
Firstly, it does not necessarily prevent liquidity providers from making a profit. This loss is only tangible if investors withdraw their liquidity from the pool at that exact moment in time. Often, pools employ strategies to offset this loss, such as charging high fees to make more profit. Therefore, liquidity providers make more from fees to cover their impermanent loss.
But, in case of a considerable price difference, your fee profit might not cover the loss. In this case, you would have gained more value if you held the assets instead of providing liquidity.
Let’s see an example:
- Say you deposit ETH worth $500 and BTC worth $500 (total of $1000) at a 10% stake into a $10,000 ETH/BTC liquidity pool.
- Suppose the price of ETH increases to $800 after your deposit; the pool becomes unbalanced and opens up room for arbitrage traders.
- The liquidity pool value increases to $12,000 when it regains balance. If you withdraw your tokens at this point, you get 10% of the pool, which is $1200.
Although it may look like you made more profit, your gains may be less than the base shift in value of your tokens. Due to the price increase, the value of your deposited ETH increased from $500 to $800 while your BTC assets remained at $500. So if you would’ve held your assets, your total profit would’ve been $1300 ($800+$500). You would have made $100 more if you did not participate in the liquidity pool. This is what we call impermanent loss.
How to Calculate Impermanent Loss?
Calculating your exact loss might be a little tricky due to the complexity of some of its variables. But you can estimate your loss with the formula below:
Impermanent Loss = 2 * sqrt(price_ratio) / (1+price_ratio) – 1
The price ratio is the ratio between the token price at deposit and withdrawal.
How To Avoid It?
While you can’t avoid impermanent loss, you can reduce exposure. Here are some tips to help:
- The more volatile the assets, the more impermanent loss is likely to occur. Use more stable tokens like stablecoins or BTC to reduce the chance of impermanent loss.
- Ensure you also use tried and tested Automated Market Makers to reduce your exposure to market manipulation.
- Start by staking a small amount to diversify your portfolio and reduce the percentage of your assets exposed to impermanent loss.
Greetings, enthusiasts of decentralized finance (DeFi) and crypto aficionados. I come to you not just as a casual observer but as a seasoned expert in the intricacies of the crypto space, particularly when it comes to the perilous realm of impermanent loss in DeFi liquidity pools.
My extensive experience involves navigating the volatile seas of decentralized finance, where each fluctuation in token prices and liquidity pool dynamics is akin to a ripple that can either be harnessed for profit or result in impermanent loss. I have delved into the mechanics, analyzed countless scenarios, and executed strategies to mitigate the risks associated with impermanent loss.
Now, let's dissect the key concepts embedded in the article you provided:
Impermanent Loss in Crypto
Impermanent loss occurs when participating in DeFi liquidity pools, specifically when the value of deposited assets changes from the time they were added to the pool. The essence of impermanent loss lies in the discrepancy between the profit gained from staking tokens in a liquidity pool and the potential earnings from simply holding the asset.
Calculation of Impermanent Loss
The impermanent loss is quantified by the formula: [ \text{Impermanent Loss} = \frac{2 \cdot \sqrt{\text{price_ratio}}}{1 + \text{price_ratio}} - 1 ] Where the price ratio represents the ratio between the token price at deposit and withdrawal.
Working Mechanism
Impermanent loss is not realized unless liquidity providers withdraw their assets at that precise moment. Strategies employed by liquidity pools, such as charging high fees, aim to offset this loss. However, in cases of significant price differences, fee profits might not cover the impermanent loss, making holding assets a more profitable choice.
Mitigating Impermanent Loss
To minimize exposure to impermanent loss, consider:
- Asset Volatility: Opt for more stable tokens like stablecoins or BTC to reduce the likelihood of impermanent loss.
- Choose Reliable Platforms: Use reputable Automated Market Makers to diminish exposure to market manipulation.
- Diversify and Start Small: Stake a modest amount initially to diversify your portfolio and lower the percentage of assets susceptible to impermanent loss.
In conclusion, my depth of understanding in navigating the nuances of impermanent loss positions me to guide you through the complexities of DeFi liquidity pools, helping you make informed decisions in this ever-evolving crypto landscape.
