Impermanent Loss

On platforms such as decentralized exchanges (DEXs ) that use Automated Market Maker (AMM) mechanisms, Impermanent Loss appears as a temporary value discrepancy. It reflects the negative difference between the value of your assets if you had simply kept them in your wallet (hodl) and the value they have after you withdraw them from a liquidity pool.

How Impermanent Loss works

To understand impermanent loss, you need to know how a liquidity pool works on an AMM:

1. Asset Pairs: Most liquidity pools (liquidity pools) work with asset pairs (e.g. ETH/USDC, BTC/USDT).
2. Equal deposit: When depositing liquidity, you must deposit an equal amount of both assets into the pool.
3. Constant product formula (x * y = k): AMMs use a formula, most commonly $x\times y=k$, where ‘x’ and ‘y’ are the quantities of the two assets in the pool and ‘k’ is a constant. This formula ensures that, regardless of trades, the product of the quantities of the two assets remains constant.
4. Arbitrage balances prices: If the price of an asset in the pool changes significantly in external markets, the liquidity pool becomes temporarily “unbalanced” and the price of the cryptocurrency in the pool is lower than on other exchanges. Arbitrage traders will take advantage of this discrepancy: they will buy the respective cryptocurrency “cheap” from the pool and then sell it “expensive” on other exchanges, until the price in the pool realigns with the market price.
5. Value loss (on withdrawal): When you decide to withdraw your liquidity from the pool, you will receive a different amount of each asset than you originally deposited because of this rebalancing. If the total value of the assets you withdraw is less than the value you would have had if you had simply held (hodled) the assets in your wallet (without putting them in the pool), then you have suffered an impermanent loss.

Why it’s called “Impermanent”

The loss is called “impermanent” because it only becomes “permanent” (realized) when you withdraw your liquidity from the pool. If the prices of the assets in the pool return to the original ratio at the time of deposit, the impermanent loss disappears. The greater the price deviation, the greater the impermanent loss.

Suppose:

• You deposit 1 ETH and 2,000 USDC in a pool, when 1 ETH = 2,000 USDC. The total amount deposited is 4,000 USD.
• The price of ETH rises to 3,000 USDC in the market.
• Arbitrage traders will buy ETH in the pool until the price in the pool adjusts. Because of the formula $x\times y=k$, the pool will rebalance.
• When you decide to withdraw your liquidity, you might receive, for example, 0.8 ETH and 2,450 USDC.
  • The value of these assets at current prices: $(0.8\times 3\mathrm{,000})+2,450=2,400+2,450=4\mathrm{,850}\text{USD}$.
  • If you held 1 ETH and 2,000 USDC (without putting them in the pool), their value would be: $(1\times 3\mathrm{,000})+2,\text{000=\$5},000.$
• Impermanent Loss: $\mathrm{5,000}USD-4\mathrm{,850}USD=150\text{USD}$. This is your impermanent loss because you gained less than if you had just “hodled” (held) the assets.

Why do liquidity providers accept this risk?

Although impermanent loss is a risk, liquidity providers are compensated through the transaction fees generated by the swaps that occur in the pool. In many cases, these fees exceed the impermanent loss, resulting in a net profit. However, in highly volatile markets or with pairs with large price divergences, the fees may not be sufficient to cover the loss.

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