What is Impermanent Loss when providing liquidity to AMM?

If you’ve ever entered the DeFi market, you’ve certainly heard the term. Impermanent Loss or temporary loss means a decrease in the value of the initial margin cryptocurrency when providing liquidity to AMM (Auto Market Maker). This happens because the ratio between the pair of coins you provide liquidity changes when the market is volatile.

General overview of Impermanent Loss

DeFi protocols like Uniswap, SushiSwap, or PancakeSwap have seen an explosion in volume and liquidity. These liquidity protocols essentially allow anyone who owns a cryptocurrency to become a market maker and earn transaction fees.

Impermanent Loss occurs when you provide liquidity to the liquidity pool and the price of your deposited asset changes from when you first started margining. The larger this change, the higher the temporary loss. In this case, the loss is calculated in USD valueless at the time of withdrawal than at the time of deposit.

Impermanent Loss is one of the characteristic weaknesses of AMM compared to traditional exchanges. Due to the nature of AMM which does not have order books but is only a pool of crypto pairs, when a trader withdraws a certain amount of cryptocurrency from the pool, he makes the coin ratio in the pair. element in the pool is changed. This can lead to the loss of liquidity providers.

So, why do liquidity providers still provide liquidity when they can face potential losses? In fact, Impermanent Loss can be offset by the transaction fees they receive. In fact, although pools on Uniswap often experience Impermanent Loss, users can still profit by enjoying transaction fees.

Uniswap charges 0.3% for each direct trade and sends it to liquidity providers. If a lot of trading volume occurs in a given pool, it can be profitable even if the pool suffers from Impermanent Loss. However, this depends on the protocol, specific pools, deposited assets, and even broader market conditions.

How does Impermanent Loss happen?

Let’s go through an example of how a temporary loss occurs with a liquidity provider.

Kaz deposits 1 SOL and 100 USDT into the liquidity pool. In this particular AMM, the deposited token pair must be of equal value. This means that the price of SOL is 100 USDT at the time of deposit. This also means that the USD value of Kaz’s deposit is $200 at the time of deposit.

In addition, there are a total of 10 SOL and 1,000 USDT in the pool – contributed by other liquidity providers like Kaz. So Kaz has 10% of the pool and the total liquidity is 10,000.

Let’s say the price of SOL rises to 400 USDT. When this happens, arbitrageurs will add more USDT to the pool and pull SOL out of it until the ratio reflects the correct price. Remember that AMM does not have an order book. What determines the price of the assets in the tank is the ratio between them in the tank. While liquidity was unchanged in the pool (10,000), the ratio of assets within it changed.

If SOL is currently priced at 400 USDT, this means that the ratio between the SOL price and USDT in the pool has changed. There are now 5 SOL and 2,000 USDT in the pool, thanks to the work of arbitrageurs.

So Kaz decided to withdraw her money. As we learned earlier, she is entitled to 10% of the tank shares. As a result, she gets 0.5 SOL and 200 USDT, for a total value of 400 USDT. She has made some significant profits since she deposited $200 worth of tokens, right? But wait, what if she only holds 1 SOL and 100 USDT? The total dollar value of these holdings would be $500 at this time.

In fact, Kaz can earn more if she just HOLD this money in her wallet, instead of putting it in the Uniswap pool. This is what we call temporary loss. In this case, Kaz’s loss is negligible because the initial deposit is a relatively small amount. However, keep in mind that temporary losses can lead to a large loss (making up a significant portion of the initial deposit).

As in the example, Kaz has absolutely no interest in the transaction fees she will earn to provide liquidity. In many cases, the fees earned will cover losses and generate profits for the liquidity provider. Even so, it is important that you understand the temporary loss before providing liquidity to the DeFi protocol.

How to estimate temporary loss?

In a nutshell, temporary losses occur when the prices of assets in the liquidity pool change. But how much is it exactly?

Here’s a summary of what the chart tells us about liquidity losses versus HODLing:

• 1.25x price change = 0.6% loss
• 1.50x price change = 2.0% loss
• 1.75x price change = 3.8% loss
• 2x price change = 5.7% loss
• 3x price change = 13.4% loss
• 4x price change = 20.0% loss
• 5x price change = 25.5% loss

Why is it called Impermanent Loss and risk?

Because this loss only occurs when the exchange rate between the two assets changes compared to when you deposited it. They will return to their old value if the exchange rate of the two assets restores to the original value. However, Impermanent Loss can turn into permanent loss if their rates never return or if you withdraw your funds from the liquidity pool once the rate has fluctuated.

The loss is temporary because the loss only materializes when you withdraw your funds from the liquidity pool. However, at that point, Impermanent Loss becomes a permanent loss. The fees you earn can make up for those losses, but it’s still a misleading name.

Be very careful when you deposit to an AMM. As we discussed, some liquidity pools suffer more Impermanent Loss than others. As a simple rule of thumb, the more volatile the assets in the tank, the more likely you are to suffer Impermanent Loss. So you better start by making a small deposit. This way, you can get a rough estimate of how much profit you can get before committing to a more substantial deposit.

The bottom line is to look for more AMMs and experiment with them. DeFi makes it fairly easy for anyone to fork an existing AMM and add some minor changes to it. However, this can create errors, and it can potentially get your money stuck in the AMM forever. If a liquidity pool promises unusually high returns, that may include trade-offs and the associated risks may also be higher.

How to avoid Impermanent Loss?

Method 1: Wait for the ratio between the two cryptocurrencies to restore to the original

Since these are only temporary losses, they will disappear if the exchange rate between the two coins returns to normal

Consider the example at the beginning of the article. If the price of SOL returns to its original $100, the temporary loss rate will return to 0%. However, this way is not optimal due to the unusual fluctuations of cryptocurrencies, the exchange rate between them may never return to the original. At this point the temporary loss becomes permanent.

Method 2: Stop providing liquidity when the market is about to be volatile

This method is very easy to understand. You will not have Impermanent Loss if you do not provide liquidity.

You should apply this action when the coin is about to enter a period of strong growth. At this point, the profit of the liquidity provision could not make up for the temporary loss, so it is advisable to stop providing liquidity.

Method 3: Choose liquidity pools with greater profits than Impermanent Loss

You may not know that the profitability of providing liquidity is based on trading volume. Therefore, the higher the liquidity pool with the higher trading volume, the greater the profit. You can look to AMM’s most profitable liquidity pools to cover losses.

Method 4: Choose liquidity pools with low volatility

Since temporary losses take place because of price fluctuations, crypto pairs with a high degree of stability will have very small temporary losses. You can choose stablecoin pairs like USDC/USDT to farm for liquidity, they will not be able to cause you losses, in return, their profits are usually low.

Summary

Impermanent Loss is one of the fundamental concepts that anyone looking to provide liquidity to AMM should understand. In short, if the asset’s price changes since the deposit, the liquidity provider may suffer temporary losses. In a difficult market situation and under pressure from bears, choosing to farm in liquidity pools is also a consideration for investors to gain profits.

DISCLAIMER: The Information on this website is provided as general market commentary and does not constitute investment advice. We encourage you to do your own research before investing.

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Harold

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