A Guide to Understanding Impermanent Loss

While liquidity remains constant in the pool , the ratio of the assets in it changes. The DeFi space is now at its peak and anyone can fork an existing project, adding only minor changes to it. This can cause errors in the operation of the protocol and lead not to temporary, but to quite real losses. Many people often interpret IL incorrectly, adding fees, spreads, and slippage to this value.

Sonic is made up of a collection of DeFi protocols that enable users to issue their own tokens, trade their tokens, and earn rewards by providing liquidity. Sonic brings users permissionless swaps where they can https://xcritical.com/ deposit a token and automatically be returned the token they want. I hope this article helps beginner and experienced users better understand the underlying risk of providing liquidity and impermanent loss.

How to Calculate Impermanent Loss?

Bancor is another platform that has implemented oracles with its liquidity pools to help minimize impermanent loss. Since oracles can provide data from external sources, the liquidity pools can be fed data of the price of assets from other exchanges. This can help the liquidity pools adjust prices accordingly instead of solely relying on the ratio of the pool to determine the price of the tokens. Since impermanent loss becomes worse the more the ratio changes, this can allow liquidity pools to remain closer to a 50/50 ratio, which may significantly reduce the risk of impermanent loss. Impermanent Loss often occurs when you have two independent assets artificially bound together in a defined ratio. When you provide liquidity in a liquidity pool , the two assets are algorithmically bound together by the system to ensure that both sides of your pool share will have the same dollar value.

If the liquidity pool were to be ETH/LINK then the risk of impermanent loss could be higher as both tokens have the potential to be volatile. Liquidity pools can also be made up of purely stablecoins, like DAI and USDC. This significantly reduces the risk of impermanent loss because stablecoins have almost no volatility, which will allow the pool to remain extremely stable. Using automated exchanges, investors can deposit their coins into liquidity pools and in return receive rewards , which are calculated in proportion to the shares of the investment. Usually, LPs are also awarded project tokens, which give them the right to vote on decisions to make key changes to the protocol and act as a kind of project shares. Providing liquidity has proved to be one of the most popular strategies for users who want to generate yield rather than simply holding assets.

What is Impermanent Loss in DeFi?

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If the TEMPLE price goes higher, more TEMPLE will be taken out by users seeking profits, and more FRAX will be added to the pool. The liquidity stays the same but the ratio of assets in the pool changes. DEXs require liquidity to allow users to trade on their platforms without incurring high slippage.

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On the other hand, the fees could help in compensating for the losses, which are actually permanent. So, it is quite crucial to evaluate the risks of IL before investing in AMMs. Interestingly, you could find liquidity pools made purely of stablecoins such as USDC and DAI, which reduce the risk of IL. Stablecoins do not have any volatility and can help in maintaining stability of the pool effortlessly. One popular method to earn with crypto is what’s known as liquidity providing or (LP.) Liquidity providers can earn trading fees by becoming what is known as an automated market maker or AMM.

• Parcl does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations.
• However, you could not benefit from an unprecedented rise in the market.
• It’s also important to note that impermanent loss does not take into account trading fees that investors earn for providing liquidity, which in many cases can negate any losses.
• Learn about the presence of impermanent loss when providing liquidity and the risks of using an AMM in this article.

On the other hand, you could also employ some promising measures for resolving the risks of impermanent losses. For example, you can invest in trading pairs with stablecoins or tokens with low volatility. DeFi platforms have also been incentivizing users to add liquidity to their pools. This is usually what is liquidity mining done by also giving rewards based on your share of the pool. On Uniswap, liquidity providers can also earn UNI tokens as an extra reward on top of the yield from providing liquidity. This can further increase profit for liquidity providers while simultaneously decreasing the impact of impermanent loss.

Let’s say, after 12 months, we decide to remove our liquidity from the pool. At the time of the removal, DAI held its peg of $1, and Imaginary Token appreciated to $5,000. The volatility in price between DAI and Imaginary Token has led to impermanent loss because our liquidity will now primarily be denominated in DAI. But, in case of a considerable price difference, your fee profit might not cover the loss.

Automated Market Makers and Liquidity Pools

By providing liquidity, traders can generally earn a competitive interest rate on their staked holdings. When you go to withdraw your share, your loss is calculated, and is subsidized with RUNE from the reserve. Most would argue that the earnings would eventually cancel out the price changes. S a window of opportunity for arbitrage traders to swoop in and buy the token for cheap. If ETH is now 400 DAI, the ratio between how much ETH and how much DAI is in the pool has changed. There is now 5 ETH and 2,000 DAI in the pool, thanks to the work of arbitrage traders.

This loss typically occurs when the ratio of the tokens in the liquidity pool becomes uneven. Although, impermanent loss isn’t realized until the tokens are withdrawn from the liquidity pool. This loss is typically calculated by comparing the value of your tokens in the liquidity pool versus the value of simply holding them. Since stablecoins have price stability, liquidity pools that utilize stablecoins can be less exposed to impermanent loss. Depending on the price fluctuations of the assets you staked, you may have slightly less of one of the assets depending on the market prices at the time.

But instead, he’s got $3535, give or take, in ETH, and a similar amount in stablecoins, totalling $7071 at current market prices. In addition, assume there is a total of 10 $AAA and 1000 $BBB in the pool – funded by other liquidity providers. So, Alice has a 10% share of the pool, and the total liquidity is 10,000 USD.

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From a glance, it seems like it makes no sense for users to provide liquidity to AMM’s, but there is more. Impermanent loss has been factored in by these DEX’s, so they give liquidity providers incentives to combat this risk. Typical AMM’s allocate a .3% trading fee to liquidity providers, which allows LP’s to profit based on the transaction volume. It indicates how much more the value of your assets would be if you just HODL instead of providing liquidity. This gap is “impermanent” because it is possible to close the gap if the token price returns to the former price.

Impermanent loss is a loss of funds that a user will incur when they provide liquidity. The name impermanent stems from the fact that the loss is temporary and can be recovered if asset prices return to their original state, which often does not happen. This loss is calculated based on your deposited assets’ worth at the time of deposit versus each asset’s current value.

Understanding impermanent loss

At the time of providing liquidity, Imaginary Token is priced at $1,000. Because it is a 50/50 pool, we will supply 500 DAI ($500) and 0.5 Imaginary Token ($500) to the pool. While this is happening, arbitrageurs are incentivized to add $BBB and withdraw $AAA from the pool until the reserve ratio reflects the current market price. It is important to remember that the price of the assets in the pool is determined by their reserve ratio, so while liquidity remains constant in the pool , the ratio of the assets in it changes.

It is important to point out that THORChain allows you to enter a pool with a different ratio than 50% of each asset (up to 100% of only 1 asset, called asymmetrical entry). The impermanent loss protection will be calculated AFTER both currencies have been rebalanced to 50% each. This can have unexpected results when comparing HODL values and the received protection. Impermanent loss can arise when there is a price discrepancy between the two assets a trader holds on a DEX, usually a cryptocurrency and a stablecoin . When the price of the cryptocurrency falls relative to the stablecoin, the trader can experience a loss due to the difference in prices.

When depositing into a pool, you must also put an equal amount in value for both tokens. Then, if the entire pool contains 10 ETH and 1000 DAI after your deposit, your total share is 10%. Let’s go through an example of how impermanent loss may look like for a liquidity provider.

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Since trading fees go to liquidity pools, your yield is determined by how many people are using your liquidity pool. If the ratio is 95/5 but nobody is using the pool to trade then you will acquire little or no yield on your deposits. If you stake A/B and tokens and B is traded a considerably higher volume than A, you are at risk of losing a small amount of B as the result of your providing liquidity.

However, compared with simply buying and holding the staked assets in the contributed amounts, the user may still be incurring losses. Note that the above does not take into account the trading fees which go to the liquidity provider, nor any rewards that may result from the staking of LP tokens. These benefits may well outweigh the impermanent loss by a significant margin. SourceSonic is an open DeFi suite open internet service built on the Internet Computer blockchain that offers an AMM without gas fees due to the reverse gas model of the IC.