Everyone in DeFi must’ve heard of impermanent loss. But only few really understands what it really is. Impermanent loss happens when there’s a change in the price of your tokens compared to when you staked them.
While providing liquidity is supposedly profitable, it can cause you some losses however, as well as gains too if you know how to take advantage of market movements.
What really is impermanent loss?
Impermanent loss happens when there’s a change in the dollar value of your crypto asset. If the change is bigger, then your loss will be bigger too.
But how does this work? Let’s look at a typical scenario:
Raya deposits 1 BNB and 100 WEX in a liquidity pool (assuming one WEX = $1). In this particular automated market maker (AMM), the deposited token pair needs to be of equivalent value. This means that the price of one BNB is 100 WEX at the time of deposit. This also means that the dollar value of Raya’s deposit is 200 USD at the time of deposit.
In addition, there’s a total of 10 BNB and 1,000
WEX in the pool – funded by other LPs just like Raya. So, Raya has a 10% share of the pool, and the total liquidity is 10,000.
Let’s say that the price of BNB increases to 400 WEX. While this is happening, arbitrage traders will add WEX to the pool and remove BNB from it until the ratio reflects the current price. Remember, AMMs don’t have order books. What determines the price of the assets in the pool is the ratio between them in the pool. While liquidity remains constant in the pool (10,000), the ratio of the assets in it changes.
If BNB is now 400 WEX, the ratio between how much BNB and how much WEX is in the pool has changed. There is now 5 BNB and 2,000 WEX in the pool, thanks to the work of arbitrage traders.
So, Raya decides to withdraw her funds. As we know from earlier, she’s entitled to a 10% share of the pool. As a result, she can withdraw 0.5 BNB and 200 WEX, totaling 400 USD. She made some nice profits since her deposit of tokens worth 200 USD, right? But wait, what would have happened if she simply holds her 1 BNB and 100 WEX? The combined dollar value of these holdings would be 500 USD now.
We can see that Raya would have been better off by HODLing rather than depositing into the liquidity pool. This is what we call impermanent loss. In this case, Raya’s loss wasn’t that substantial as the initial deposit was a relatively small amount. Keep in mind, however, that impermanent loss can lead to big losses (including a significant portion of the initial deposit).
With that said, Raya’s example completely disregards the trading fees she would have earned for providing liquidity. In many cases, the fees earned would negate the losses and make providing liquidity profitable nevertheless. Even so, it’s crucial to understand impermanent loss before providing liquidity to a DeFi protocol.
There’s something important you also need to understand. Impermanent loss happens no matter which direction the price changes. The only thing impermanent loss cares about is the price ratio relative to the time of deposit. If you’d like to get an advanced explanation for this, check out pintail’s article.Â
The term impermanent loss is that way because this loss only becomes permanent when you remove the liquidity you have provided.
It is also far more profitable if you are providing liquidity for a long time.
If you intend to pull out liquidity in just a few days, then you should just hodl or trade.
