Understanding impermanent loss What is impermanent loss and how it can by Alex Beckett Coinmonks

DeFi protocols like Uniswap, SushiSwap, or PancakeSwap have seen an explosion of volume and liquidity. These liquidity protocols enable essentially anyone with funds to become a market maker and earn trading fees. Democratizing market making has enabled a lot of frictionless economic activity in the what is liquidity mining crypto space. Overall, these figures are essential to keep in mind as they give liquidity providers an idea of how much they should be compensated while providing liquidity. If a user knows they will receive more in rewards than lost in IL, it is most likely a no-brainer to provide liquidity.

This rings especially true in the bull market phase as crypto markets are highly auto-correlated. This calculator uses Uniswap’s constant product formula to determine impermanent loss. While there is some disagreement on the significance of impermanent loss, it’s a phenomenon worth noting as you allocate your portfolio. While these ratios can potentially water down the effects of impermanent loss, they can also backfire and cause major losses. Our guide fully explains how an impermanent loss occurs, how to calculate it, and how to avoid it using simple English – no technical jargon. In a traditional AMM, the aggregate dollar value of two assets in a fully arbitraged AMM is always equal.

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If you’ve been involved with DeFi at all, you almost certainly heard this term thrown around. Impermanent loss happens when the price of your tokens changes compared to when you deposited them in the pool. As price fluctuates and one asset outperforms another, you end up selling the more expensive asset for the “lagging” one. This acts as a portfolio that rebalances profits into the underperforming token. This rebalancing can be extremely powerful, considering how heavily correlated crypto assets are. If and when the other token “catches up”, it will have allowed the user to maximize the gains as the user caught both of the assets rallies.

It would have grown to $15,000, a 50% profit in a month, which is very unlikely to happen with liquidity mining rewards. Let’s say you deposit an equal amount of ETH and USDT to an ETH-USDT liquidity pool. This guide will explain how impermanent loss happens, what it really means and what it would actually require to avoid this from happening. Let’s take a look at some examples of impermanent loss to better understand how it works. Sunflower Corporation — a new cryptocurrency derivative exchange focused on the best trading experience and tech excellence. Understanding Impermanent Loss is necessary for any user of AMM platforms.

What is Impermanent Loss (IL)

As tokens are exchanged in the pool, the quantity of tokens changes, leading to a concept known as “price impact,” where each purchase affects the price of the purchased token. In the case of common liquidity pools such as in Uniswap, you could find a constant formula-based algorithm for ensuring that values of the two cryptocurrencies in the pool are the same. At the same time, the algorithm also ensures the provision of liquidity, irrespective of the magnitude of the transaction.

Calculate impermanent loss by comparing the value of an LP’s pool share when providing liquidity to its current value. This calculation considers the price changes of the assets in the pool and the LP’s share of the pool. Impermanent loss is a temporary loss of value that liquidity providers (LPs) can experience when providing liquidity to DEX pools.

The only thing impermanent loss cares about is the price ratio relative to the time of deposit. If you’d like to get an advanced explanation for this, check out pintail’s article. The key is weighing the opportunity costs of HODLing assets individually vs. LPing them to earn extra rewards at the expense of impermanent loss. If the liquidity rewards outweigh the IL potential, then why would a user not participate in liquidity provision? With every investment, that is the most challenging part, recognizing and understanding the most optimal investment. Reductively, let’s say a provider needs to supply comparable levels of liquidity in both DAI and ETH, but the price of ETH suddenly rises.

To overcome this limitation, platforms such as Balancer offer pools with different weights and a variable number of assets. For instance, one of the most popular pools on Balancer is BAL-ETH, where the weight of the BAL side of the pool is 80%. This means that changes in the price of ETH (positive or negative) will not affect the pool that much compared to a 50/50 split. You should not construe any such information or other material as legal, tax, investment, financial, cybersecurity, or other advice.

What is Impermanent Loss (IL)

This fee applies to transactions conducted through Uniswap’s official frontend and involves specific digital assets like USDC and ETH. The decision aims to maintain Uniswap’s trading volume across DeFi aggregator services and fund further crypto and DeFi development efforts. The arrival of Web3 projects and DAOs has necessitated the creation of tools to streamline and manage treasury assets. This is needed to optimize business liquidity while mitigating financial, operational, and reputational risks.

  • I highly suggest touching upon the subject to better understand Impermant Loss, especially for those who do not know how DEX’s operate.
  • Sometimes, you might not lose your money, but the gains could be relatively less than expected.
  • What you need to know is that it is a number that changes only when someone adds or removes liquidity, or when fees are collected on trades.
  • Liquidity providers take on this risk when adding tokens to a pool in order to earn trading fees.
  • The liquidity pool includes ETH and DAI tokens with equal weightage for ensuring improved ease of trading for users.

Amberdata said that their endpoint tools don’t take shortcuts when it comes to calculating impermanent loss. Their application collects liquidity pool data from across exchanges and tracks activity to get accurate, customized calculations. When you provide liquidity to a pool, you deposit an equal value of each https://www.xcritical.in/ asset (e.g. $100 of ETH and $100 of DAI). The total liquidity in a pool can change when trading fees are added, or when a liquidity provider adds or removes their liquidity. In fact, you may not actually lose any money, but rather your gains are less relative to if you had just left your assets untouched.

In our example, the LP stands to lose nearly 2,000 USDT in the process of providing liquidity to a DeFi protocol. Though this process is called impermanent loss, the term is slightly misleading. The meaning of impermanent loss is actually very similar to the concept of unrealized loss. The loss could reverse in theory (if the LP doesn’t withdraw their assets and the ETH price returns to original levels), but there is no guarantee of that happening. It is important to note that while these strategies can help reduce the risk of impermanent loss, they do not guarantee that you will not experience a loss. Trading on DeFi platforms carries inherent risks, and it is important to thoroughly understand these risks and carefully consider whether DeFi trading is right for you.

On the other hand, the fees could help in compensating for the losses, which are actually permanent. So, it is quite crucial to evaluate the risks of IL before investing in AMMs. Everything looks quite seamless until now with a liquidity pool, and there is no sign of impermanent loss anywhere.

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