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What is Impermanent Loss
What is Impermanent Loss_
Cryptocurrency
21.12.2021
Updated 14.01.2022
7:33

Many users who are interested in decentralized finance and use DeFi-exchangers regularly invest their money in liquidity pools. Doing so they will sooner or later come across such a concept and phenomenon as “Impermanent Losses / Impermanent Losses”.

In this article, you will learn what non-permanent losses are, how they appear and disappear, and how to avoid them.

What are impermanent losses

Today’s DeFi protocols allow any user to upgrade to market maker status and earn based on the commission they receive. To do so, you need to send your cryptocurrency assets to a liquidity pool, where an automated system will use them to secure trades on a pair of tokens.

Thanks to this mechanism, you can provide a good passive income, which does not require high skills, the use of sophisticated equipment or significant investments. However, there are risks – there is a probability of withdrawing less than the amount that was initially sent to the pool. This parameter is called the impermanent loss.

The Impermanent Loss is a measure of the loss of funds relevant to automatic market maker (AMM) liquidity providers due to the volatility of the pool’s trading pair. It demonstrates how much more the user’s assets would be valued if the user just kept them instead of sending them to the pool for passive income.

How impermanent losses appear and disappear

Non-permanent losses arise in two situations:

  1. If the value of one of the pool’s assets changes and the price tag of the other stands still.
  2. If asset prices move in opposite directions.

Non-permanent losses are called such because they can disappear. All it takes is for the prices of the pool’s assets to return to their previous (original) ratio.

Non-constant losses can only move to the permanent section if the market maker withdraws its assets from the pool at a time when the return to the previous ratio has not yet occurred. Thus he will fix his losses.

Example of a volatile loss

We will describe the situation with the occurrence of a volatile loss using the example of liquidity pool operation through an automatic market maker:

At the time of pool creation, the first liquidity provider has the ability to independently set the initial price by sending tokens into the pool in the desired ratio. All subsequent providers have no ability to influence the rate, as the rules state that they send two coins into the pool in the same dollar equivalent.

If an investor wants to provide $2000 liquidity to the same ETH / USDT pool, he will need to send $1000 in cryptocurrency to each of the two destinations. At the exchange rate it will be 1 ETH and 1000 USDT. Immediately after that, he will receive liquidity tokens, which are a kind of receipt for the right to return the investment in the future.

Each user who will use the pool to exchange cryptocurrencies will deposit one coin and withdraw another, thus changing the ratio of coins and affecting their value according to the formula described above. This can result in a situation where the price of the asset in the pool differs from the actual market price.

As long as the total dollar value was the same, everything was fine. But as soon as one of the assets starts to rise on the outside market, traders will come into play and start buying ETH from the pool at a tempting price that is below the market value until the value equals the outside actual figure.

Suppose the value of 1 ETH has risen to 4,000 USDT. If a liquidity pool investor at that moment tries to withdraw his investment, he will actually receive 0.5 ETH and 2000 USDT. The amount of the returned investment would be $4,000. Seems like a good deal. But if he was just walking cryptocurrency, storing it in a regular wallet, then after price increase his 1 ETH and 1000 USDT would be valued at 5000 dollars. The $1,000 difference is the non-permanent loss.

Estimating Non-Permanent Losses

A volatile loss occurs when the value of one cryptocurrency changes in relation to another. This gives rise to unrealized gains. Its size depends on how many times the value has changed:

But, in any case, these are losses from potential profits and it is unrealistic to withdraw from a competently created pool less than you invested.

How to prevent impermanent losses

Preventing volatile losses or minimizing these values can be realized through:

An additional positive point is the mechanism of decentralized exchangers, in which the coverage of non-permanent loss and the stimulation of providing liquidity occurs at the expense of charging commissions. Users conducting exchanges pay it, and then this amount goes to the accounts of liquidity providers, forming their earnings.