What Is Impermanent Loss?
Impermanent Loss is one of the terms you will come across within the DeFi world. Within the DeFi yield farming world, impermanent loss occurs when the price of a token increases or falls after you have deposited it in a liquidity pool.
The price change is considered a loss when the value of the tokens at the time you withdraw drops to below the value when you deposit them. With the proper knowledge, you can get the exact percentage lost for a given price change.
The Risk of Impermanent Loss
After finding what is impermanent loss, the next question that flashed in everyone’s mind is what are the risks of impermanent loss. As with anything else in the crypto world, it is all about weighing risk versus reward. Pools with assets whose price range is relatively tiny have less exposure to the risk of impermanent loss crypto. These assets include stablecoins and wrapped tokens.
While there is always a risk of impermanent loss, there is also a reward. Most pools provide a mechanism where liquidity providers will get rewards from the trading fees. As a result, it helps mitigate some risks due to the potentially colossal reward when one provides liquidity.
One example is Uniswap, where each trade is charged a 0.3% fee. This fee goes directly to the liquidity providers. If there is a huge trading volume in a given pool, it can be profitable to provide liquidity even when the risk of impermanent loss is high. However, it will depend on the protocol, the given pool, the assets in the pool, and the market conditions. You can also face impermanent loss yield farming.
How Impermanent Loss Occurs
Let us take an example of A, who deposits 1 ETH, and 100 DAI in a pool. In this case, the automated market maker (AMM) requires that the deposited pair be of equal value. It means that the price of Ethereum was 100 DAI when the tokens were deposited. When A made the deposit, its dollar value was $200.
Additionally, there is a10 ETH and 1000 DAI in the pool, funded by other liquidity providers. So A has a 10% share in the pool with total liquidity of 10,000.
Over time, the price of ETH rises to 400 DAI. While it happens, arbitrage traders add DAI to the pool and withdraw ETH until the ratio returns to the current price. In a pool, there is no order book. As such, the price of assets is determined by the ratio between them. While the liquidity does not change, the ratio of the assets changes.
With ETH valued at 400 DAI, the ratio between ETH and DAI changes in the pool. There is now 5 ETH, and 2000 DAI, thanks to arbitrage trading.
A then decides to move her funds out of the pool, according to earlier figures, she is entitled to 10% of the pool. As such, A can take out 0.5ETH and 200 DAI, worth $400. It would appear that A’s initial deposit has grown two-fold from $200 to $400. However, what if A had held on to her $1 ETH and 100 DAI? She would now have a dollar value of $500.
From the example above, A would have made more profit by simply holding onto their ETH instead of placing it in the liquidity pool. While A made a small initial deposit, her loss was negligible. However, the loss could have been much more significant if A made a bigger deposit. This is what impermanent loss looks like.