Impermanent Loss is a major concern for liquidity providers in decentralized finance (DeFi). This is the case when an asset’s price in a liquidity pool increases or decreases dramatically. This makes the appreciation value of a liquidity provider’s contribution less attractive than simply holding the assets outside of the pool. This loss largely wipes out any potential profit which makes it a very important issue for those engaging in DeFi trading.
Impermanent Loss is a common phenomenon that occurs from price changes of assets in automated market maker (AMM) liquidity pools. AMMs allow for a decentralized, algorithmic arbitrage mechanism to automatically balance token values. When the price of an asset increases or decreases, the ratio of that asset in the pool adjusts instantly. This change, in turn, has downstream impacts on liquidity providers, who currently provide the tokens that fuel these deep pools.
The main driver behind Impermanent Loss is the price difference of assets in a liquidity pool. Whenever the asset’s price in the pool moves out of alignment with its price outside the pool, arbitrageurs spring into action. Almost as fast, they move in to rebalance the pool. This rebalancing incentivizes liquidity providers to sell the asset that has appreciated in price. Simultaneously, they’re purchasing the asset that has depreciated.
When that happens, the value of the liquidity provider’s contribution recedes further. That’s because the other adjusted ratio makes them functionally high selling-low buying, which eats away at their profit margins. Referring to this effect as Impermanent Loss emphasizes that this loss is still unrealized. It does not come into existence until the liquidity provider redeems their capital from the pool. Assuming the price ratio goes back to where it started, the initial loss is able to be recouped.
Just because IL is hard to avoid doesn’t mean it isn’t a major fear for LPs. It directly affects their expected earnings and can in some situations completely negate the trading fees earned from providing liquidity. For instance, if a liquidity provider deposits tokens into a pool and the price of one token doubles, they may experience a significant loss when withdrawing their funds.
The degree of Impermanent Loss only exists based on the degree of price divergence. It’s a common understanding that with small price hikes come small loss increases. Big price drops lead to deep losses in value. Liquidity providers must carefully assess the risk of Impermanent Loss when choosing which pools to participate in, often weighing the potential rewards against the risks.
There are a few different strategies to protect yourself from Impermanent Loss. One strategy is to only provide liquidity to pools made up of stable assets in which price changes are negligible. Second, when equity pools are used, they should be actively monitored to aggressively manage pool performance and reposition capital to minimize losses on a consistent basis. A few DeFi platforms have implemented insurance or compensation models to shield liquidity providers from Impermanent Loss.
So getting to know Impermanent Loss is important for anyone who’s joining in on DeFi as a liquidity provider. It takes significant financial literacy, a deep understanding of how AMMs work, and an understanding of how price volatility can affect your return on investment. An awareness of these dynamics allows liquidity providers to better inform their decisions and risk exposure.
