What is Impermanent Loss?
Most, if not all, Automated Market Makers (AMMs) such as Uniswap, THORChain, and Serum DEX, use liquidity pools to determine the price of assets. The idea of a liquidity pool is that anyone can come along and deposit one asset and take another asset of equal value out. This is why it is called a swap – the user is literally swapping one asset for another rather than placing bids or asks on an order book.
The above diagram shows an example of what happens to a BTC/ETH liquidity pool as ETH is added to a pool in return for BTC. Notice that the more ETH is added to the pool, the less BTC there is, therefore the less BTC that is gained by adding more ETH. If a pool becomes unbalanced, then arbitrage traders see an opportunity to add more BTC to the pool which would yield substantially more ETH in proportion to the USD value. Thus, it is arbitrage that keeps the pools balanced rather than any internal mechanism.
As with most yield bearing investments, your capital is at risk through natural price action. However, when providing liquidity to an LP, this can also lead to something called ‘Impermanent Loss’.
Impermanent Loss is a phenomenon unique to liquidity pools whereby liquidity providers can sometimes end up with less value than what could have been realised by simply HODLing the staked assets. Here’s a simplified example for a BTC/ETH pool:
- A liquidity pool has 10 BTC and 40 ETH. This implies a Bitcoin price of 4 ETH.
- For this example, we’ll assume Steven enters this pool as liquidity provider with $100,000 (1 BTC & 4 ETH) which gives him a 10% share in the pool which has a Total Value of $1,000,000.
- After 100+ days, BTC goes up 5X while ETH goes up 10X.
- The pool ratio would be out of balance and gets rebalanced by arbitrage traders.
- Now the price of BTC would be equivalent to 2 ETH (ETH has doubled in value against BTC in this example 10/5 = 2X).
- Since the liquidity doesn’t change in the pool, arbitrage traders bring the ratio back to 50/50 by withdrawing ETH and adding BTC. In this case, they bring the assets in the pool to 15 BTC and 30ETH.
- Steven’s LP funds are determined by his share in the pool, not the number of coins he has provided so Steven’s 10% share is 1.5 BTC and 3 ETH. When denominated in ETH, this amounts to a total of (1.5 * 3) + 2 = 6.5 ETH.
- Had Steven simply HODLed his 1 BTC and 4 ETH he would have had the equivalent of (1 * 4) + 4 = 9 ETH.
- This 1.5 ETH (9 – 6.5) difference is called an Impermanent Loss.
‘Impermanent Loss’ implies that the loss is temporary, and indeed is only realised when the liquidity provider decides to remove their funds from the pool. The idea is that any short-term loss caused by this phenomenon will be made up longer term through the yields and rewards paid out for providing liquidity.
It is important to understand this mechanism before making any decisions on allocating capital to a pool. Liquidity providers should consider the length of time they would be holding their stake, the volatility of both assets and how closely they correlate with each other in order to minimise the chance of realising Impermanent Loss.
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Disclaimer: THIS IS NOT FINANCIAL OR INVESTMENT ADVICE. Only you are responsible for any capital-related decisions you make and only you are accountable for the results.