Impermanent loss is an important concept for anyone active in decentralized finance (DeFi), especially those who provide liquidity. This is a phenomenon that occurs when asset prices in a liquidity pool diverge. As a result, you might be incurring a negative return versus simply holding the assets. Here’s why Understanding impermanent loss is key for DeFi investors looking to make sense of the automated market maker (AMM) Enron-style shell game.
Impermanent loss can be quantified. For instance, a 50:50 liquidity pair experiencing a 100% price increase in one asset will face an impermanent loss of approximately 5.72%. Since this loss can provide the bulk of their profitability, this loss becomes a key factor when judging if supplying liquidity is profitable.
To better understand how this works, let’s take an example of one Alice who deposits 1 ETH and 1,000 USDC into a liquidity pool. First, set the price of 1 ETH to be 1,000 USDC. If ETH’s price suddenly rises to 4,000 USDC, arbitrageurs will very rapidly rebalance the pool. Then, they will ensure that it truly works to reflect this new price.
These credits have not changed the overall size of the pool but have affected the qualitative make-up of the pool. At the time of withdrawal, Alice is able to withdraw less ETH but more USDC than the ETH she deposited. This difference is the impermanent loss, caused by the price appreciation in ETH.
The extent of impermanent loss is largely determined by three main factors. Unevenly weighted assets in a pool disproportionately suffer the consequences. This effect is further amplified in pools that include more than two tokens. The greater the diversity of the assets and their weighting, the more sophisticated the impermanent loss calculations need to be.
Impermanent loss can be avoided, and indeed made into an advantage, with frequent compounding. Frequent compounding — hourly, daily — can have enormous effects. The returns produced typically well exceed the effects of impermanent loss.
