DeFi Basics: What is Impermanent Loss?

Decentralized Finance (or DeFi) is all the rage in the crypto industry these days. With so many projects coming in, you might lose sight of something really important – security. While the blockchain technology is pretty secure, you might still incur losses on your investment.

One such loss is impermanent loss. And that is what we’re going to talk about in this article.

Before we jump right into it, here’s a quick rundown of what you’ll find in the article. If you’re a beginner, you’d probably want to read the entire article. But if you’ve been investing for a long time and know most of the things we’re talking about, feel free to skip to the section that interests you the most.

What is Impermanent loss

What is Impermanent Loss?

Automated Market Making (AMM) allows users to swap crypto assets without needing a centralized counterparty, such as DAI for PRV. This is unlike conventional exchanges that serve as intermediaries between token buyers and sellers, such as Coinbase, Kraken, Binance, etc.

One of the most significant virtues of AMMs is that certain consumers are expected to serve as providers of liquidity in the service. Liquidity suppliers contribute their own asset pairs to liquidity pools.

Since your assets are locked in the liquidity pools, you can’t benefit from any arbitration that takes place due to the difference between the market price and the AMM price for the tokens.

So you find yourself at a loss. This loss is the impermanent loss that most investors in the blockchain industry dread.

You might be wondering why it is not simply called a loss. The reason behind that is the fact that this loss doesn’t become permanent until you decide to withdraw your tokens. The AMM price for your tokens might eventually be equal to the market price. And when that happens, you would no longer be at a loss.

How Can We Reduce Impermanent Loss?

Luckily, in the battle against impermanent loss, the industry is making progress. We can reduce the probability of impermanent loss by minimizing the divergence between the prices of tokens in an AMM.

If the relative prices remain constant between tokens in an AMM, liquidity providers (LPs) bear less risk. They feel more assured that trading fees might actually make them some profit. AMMs or tokens that retain a constant price ratio (like Uniswap) have therefore proved to be especially immune to impermanent losses. Thanks to their profit-optimized structure, they attract considerable liquidity.

How Does Impermanent Loss Occur?

Before diving into how impermanent loss occurs, we first need to understand how Automated Market Making pricing functions and the role arbitrageurs play in it.

AMMs are more or less disconnected from foreign markets in their raw form. An AMM does not automatically alter its prices as token prices change on external markets. As you would expect, this opens up avenues for arbitrage.

An arbitrageur must come along and purchase the underpriced asset or sell the overpriced asset before the AMM ‘s offered prices match the external markets. The benefit derived by arbitrageurs is essentially withdrawn from the wallets of liquidity suppliers during this process, resulting in impermanent losses.

Consider an AMM with two assets, PRV and DAI, set at a 50/50 ratio, for example. A shift in the price of PRV opens up an incentive for arbitrageurs to benefit at the cost of liquidity providers. Something on these lines happens in such situations:

1) With equal values on both sides, the DAI / PRV AMM is balanced.

2) The price of PRV rises by 10 percent, providing an incentive for arbitrage.

3) Arbitrageurs are encouraged to balance AMM by exchanging DAI for PRV until the AMM is equal on both sides.

4) As a consequence, liquidity providers incur a loss of-$ 2.4 relative to holding PRV & DAI

FAQs

1. What are Liquidity Pools?

Liquidity pools are pools of tokens (or token pairs) that act as reserves for certain tokens. These reserves facilitate trade on the AMMs (thus providing these platforms “liquidity”). 

Typically, one of the tokens in the liquidity pools has to be ETH. But lately, we’ve been seeing major shifts in it. Uniswap V2, for example, has added the ERC20/ERC20 liquidity pool on its platform. This removes the need for ETH to be one of the tokens in the pool.

2. Who are the Liquidity Providers (LPs)?

In traditional markets, banks, financial companies, and principal trading firms (PTFs) serve as liquidity providers.

The liquidity providers in the DeFi industry work similarly to make trades happen. By providing liquidity to the market, they enable traders to use the digital exchanges.

3. What is Liquidity Mining? Does it Mitigate Impermanent Loss?

A  lot of liquidity pools provide additional incentives for LPs by offering liquidity mining programs. Liquidity mining, in essence, is a way of rewarding LPs with extra tokens for providing liquidity to certain pools or using a protocol.

The value of the additional tokens in some cases can completely negate the value lost by impermanent loss, making providing liquidity highly lucrative.

4. Does Impermanent Loss become Permanent?

The Impermanent loss is often irreversible, but it merely cuts into the benefits that an analogous approach would have netted in the positive case.

To mitigate this form of loss, Bancor V2 and Mooniswap have adopted techniques. The constant product AMM, Uniswap found an amazing way around it as well.

Before You Go…

Impermanent Loss risks the pledge of AMMs as a tool for democratizing the provision of liquidity and allowing passive market-making by any consumer with latent capital.

But remember, there’s a good reason why it is called “impermanent” loss and not “permanent” loss. It can be avoided.

And there are AMMs working toward removing these losses altogether. Whether they succeed in doing that efficiently is something only time can tell. But for now, all we know for certain is that these losses exist and are faced by liquidity providers across the industry.