Impermanent Loss Explained: What is Impermanent Loss?

Since the advent of DeFi in the crypto space, many protocols have been launched to empower the advantages of blockchain technology and smart contracts. However, everything has its pros and cons. DeFi is a nascent category, and it has drawbacks that limit its potential adoption. Impermanent Loss is one of the limitations of DeFi. 

Let’s explore more in this article.

What is Impermanent Loss?

Impermanent Loss (IL) is a popular term in the DeFi space. It happens when you supply your crypto assets/tokens in the liquidity pool of AMM protocols and the token price changes. Impermanent Loss is realized when liquidity providers withdraw their supply.

Liquidity pools act as the source of liquidity for AMM protocols. The bigger liquidity pools, the smaller the price impact of swaps will be. No user wants to bear a big loss from slippage when swapping a crypto for another on AMM protocols. Before digging deeper into IL, we should understand how does AMM work.

Impermanent loss has the word “loss” in its name, which every investor does not welcome. It has a huge impact on the investment when users provide their assets into liquidity pools.

How does Impermanent Loss work?

Impermanent Loss can happen in any AMM protocol in the DeFi space. At the moment, there are numerous AMM protocols running on blockchains. For more clarification, we will introduce an example of impermanent loss on Uniswap, a top AMM DEX on Ethereum.

An investor provides 1 ETH (worth $1,000) and $1,000 worth of USDT in an ETH-USDT pool on Uniswap to gain benefits. The liquidity pool has to balance the 50/50 ratio of USDT and ETH when a user trades ETH or USDT for the other.

After the deposit, the pool is now a total value of $20k (10 ETH and $10,000 USDT), and he owns 10% of the pool. If the ETH price increases by 100% due to its buy demand, the pool is no longer 50/50.

ETH increases by 10%, worth $1,100 per ETH → The number of ETH in the pool will decrease, and the number of USDT in the pool will increase to balance the 50/50 ratio. Therefore, if he withdraws his 10% share in the pool, he will get less ETH and more USDT in equal portions.

As a result, he will get less ETH and more USDT in the increasing scenario of ETH. On the other hand, he will get less ETH and less USDT if the ETH price decreases.

Above is the simplified process of how impermanent loss works. The calculation would be more complicated if the token price of 2 or more provided assets changes. In later sections, we will introduce how to calculate impermanent loss and some go-to online impermanent loss calculators.

How to calculate Impermanent Loss

Impermanent Loss is inevitable in liquidity pools of AMM protocols. How big is it exactly? Below is an estimated value (without trading fees earned) of the initial investment after the price changes.

To break down the chart, here are some IL numbers when the price changes by certain percentages:

• The token price increases by 100% = 5.72% loss
• The token price increases by 50% = 2.02% loss
• The token price increases by 10% = 0.11% loss
• The token price decreases by 50% = 5.72% loss
• The token price goes to $0 = 100% loss

To facilitate the calculating process, there are go-to websites to calculate the IL. 

• WhiteboardCrypto: whiteboardcrypto.com/impermanent-loss-calculator
• Sonar Watch: sonar.watch/tools/il-calculator
• …

How to avoid Impermanent Loss

Low-volatile pools

Investors can reduce the IL range by choosing the liquidity exposure to one stable asset with another crypto. For example, providing liquidity in an ETH/USDT pool bears less IL since only the ETH price changes, and the other does not.

Supply assets into single-sided pools

Impermanent loss only occurs when investors provide two or more types of cryptos and tokens into a liquidity pool. Single-sided exposure is the solution for IL. However, only some protocols implement this method since it requires experienced developers to build.

Price ratio to equilibrium

As its name suggests, the loss will be impermanent if investors do not withdraw their deposits. The token price in the pools changes over time. It can go up or down and back to the deposit price. Then they can withdraw the liquidity in order not to be exposed to any impermanent loss.

Stop providing liquidity at a right time

It is almost impossible to avoid Impermanent Loss since the token price always changes. We can reduce the loss by hopping out of the liquidity pool in high market selloffs or bull runs.

• During market selloff: Impermanent loss is huge since the token price drastically plunges.
• During a bull market: Rewards from liquidity provision might not be higher than the impermanent loss. Providing liquidity in pools can make investors get fewer profits than holding the token.

FAQs about Impermanent Loss

Impermanent Loss vs. Slippage vs. Price Impact

Slippage and Price Impact is a similar term that happens when a user trades one token for another on exchanges, including centralized and decentralized.

In order-book-based exchanges, it occurs when the bid price is different from the asking price.

In AMM DEXs, it happens due to a lack of liquidity or high-volatile price changes.

Impermanent Loss is realized only when liquidity providers withdraw their deposits.

Is impermanent loss inevitable?

Crypto is considered a high-volatile market. Therefore, an impermanent loss will be huge if the token price changes drastically. It is impossible to avoid it when providing liquidity into pools of AMM protocols. However, users can reduce the loss by managing the investment.

What will the impermanent loss be if the token price goes to zero?

If we deposit two types of tokens (A and B) in the liquidity pool. The starting price (deposit price) of A is $1000, and that of B is $1.  The token A price goes close to $0 over time, and B still is $1. The investment will get 99.(9)% loss if the deposit is withdrawn from the pool. 

Conclusion

Impermanent loss can cause a big change to the initial investment into liquidity pools. By understanding it, we will be able to account for the potential risks in our investments. I hope after reading this article, you will be able to understand the risks involved in Impermanent loss as well as the solutions to this issue.