Understanding Impermanent Loss & How to Minimize It

Well, it comes from an inherent design characteristic of a particular market called an automated market maker. Providing liquidity to a liquidity pool can be profitable, but you’ll need to keep the concept of impermanent loss in mind.

While decentralized finance (DeFi) has helped bring a more accessible and democratized market-making experience to investors, there remain risks that should be understood before getting involved with providing liquidity. Impermanent loss is an important factor to keep in mind.

Here’s a deeper dive into impermanent loss explained and the steps investors can take to minimize long-term losses. 

When a user provides liquidity to a liquidity pool, they typically deposit an equal value of two coins, such as Bitcoin (BTC) and Ethereum (ETH), which comprise a trading pair (BTC/ETH). Impermanent loss is where the price of the deposited assets changes, and goes lower than when the coins were deposited.

The more the value of the assets changes, the more each liquidity provider is exposed to impermanent loss. In this situation, the loss refers to the decline in dollar value at the time of withdrawal compared to the asset's value at the time of deposit. 

Pools with more volatile assets are more likely to experience more significant impermanent loss. Pools comprised of assets with a larger market cap paired with stablecoins, and wrapped versions of assets, are less likely to undergo impermanent loss. Impermanent loss yield farming is of particular concern to crypto users due to the volatile nature of yield farms.

To help offset any potential losses incurred, liquidity providers receive a share of the trading fees generated by the pool in question. In some instances, the value of the provided liquidity can wind up being worth more than the deposited initially, on top of additional value earned through trading fees.  

Impermanent loss occurs due to the basic design of liquidity pools and automated market makers (AMM). Both determine the price of an asset based on the ratio between the two assets that make up a liquidity pool. 

For example, if the price of ETH is $1000 and there is 10 ETH in an ETH/USDT pool, then there would need to be 10,000 USDT for an equal ratio. If the price of ETH rose, arbitrage traders would remove ETH from the pool and deposit USDT to help bring the asset ratio back into balance. 

However, if the price of ETH later increased to $4,000, the ETH/USDT pool mentioned before would now comprise 5 ETH and 20,000 USDT. 

If a liquidity provider contributed 1 ETH and 1000 USDT, they would be entitled to 10% of the pool. Following the increase, this same LP would be entitled to 0.5 ETH and 2000 USDT if they were to pull liquidity out.

The original value of the provided liquidity was $2000, while the value of the assets once removed is $4,000. While many would see this as a nice gain, had the liquidity provider simply held onto the original 1 ETH and 1000 USDT, the value of the assets would now be $5,000. 

Impermanent loss is the difference in value as evidenced by this example. This scenario provides a clear example of when it would be better to just hold an asset rather than attempt to earn an extra yield by providing liquidity. 

When discussing impermanent loss, it's important to remember that the value loss is highly dependent on the volatility of the assets in question. In some cases, the impermanent loss can lead to a massive loss of assets.

A second important fact to note is that impermanent loss happens regardless of which direction the price changes. Overall, when calculating impermanent loss, users need to account for the current price relative to the price at the deposit time.

Impermanent loss might sound like a challenging concept to calculate. Fortunately, an impermanent loss calculator lets users input initial and future prices to come up with impermanent loss. It’s important to note that these types of tools will not include fees.

Those interested in calculating impermanent loss by hand need to rely on the impermanent loss formula.

In simpler terms – users can first start with the constant product formula of (ETH liquidity * token liquidity = constant product). To calculate ETH liquidity, users need to follow this formula

square root (constant product / ETH price).

To figure token liquidity, use the following formula

square root (constant product * ETH price)

To avoid calculating impermanent loss and to mitigate the concern altogether, some opt for Impermanent Loss Protection (ILP) to prevent unexpected losses. One example of this concept is the Bancor Network, where the insurance coverage on a new deposit increases by 1% each day (up to the full range after 100 days).

Any loss that occurs is fully covered by the protocol at the time of the withdrawal after the 100-day period. Partial compensation is doled out between 31-99 days. However, no IL compensation will flow to users if stakes are removed within the first 30 days.

The term “impermanent loss” can be misleading. Some believe it implies losses will eventually fade away. In reality, it’s only called impermanent loss because funds are still deposited in the pool. Once removed, the loss will become (realized) permanent.

As mentioned previously, some liquidity pools are more exposed than others, and the critical thing to be aware of is the level of volatility for the assets involved. The more volatile an asset, the more likely it is that a liquidity provider for that asset will be exposed to crypto impermanent loss. 

Liquidity providers may want to test out a pool they are interested in by depositing a small amount at first to get a sense of what types of returns can be expected and what potential losses may look like. 

It's also important to properly vet the AMM in question to ensure that it has an established track record of being trustworthy and has an open-source code that allows investors to ensure that there are no backdoors that would allow the developers to drain a pool of funds. Poorly written code can also result in funds being unable to be retrieved from a smart contract, so it’s essential to use protocols that have been verified and battle-tested. 

A couple of the newer options available to help minimize exposure to impermanent loss crypto include single-sided liquidity pools and multiple asset liquidity pools.