Demystifying Impermanent Loss

The phrase “impermanent loss” is on people’s radar in the crypto space, but to those new to DeFi when they think of impermanent loss the magical sudden loss of value to their coin comes to mind. Is it a scam? Why am I losing coins instead of gaining when the price is going up? This and more will be explained but let’s start with the definition. A quick disclaimer before we start, this is not financial advice and for educational purposes only. Please ensure you do your own research before entering a liquidity pool.

 

What is Impermanent Loss?

 

Impermanent loss is the difference in price that occurs between just holding your tokens on a wallet versus having it staked as a liquidity provider (LP) in a liquidity pool.

 

But what are liquidity pools?

 

Let’s now take a dive into understanding liquidity pools. All exchanges require capital for people to trade. CEXes, or centralised exchanges, are the “market makers” by providing their clients with the financial capital needed for trades to happen, also known as liquidity.

 

DEXes, or decentralised exchanges, on the other hand use what’s called Automated Market Making, or AMMs. This enables the retail trader to passively earn exchange fees for allowing retail investors to pool their assets together to provide the DEX with liquidity. While their assets are in the pool, they are exchanged with an LP token, which represents the value of their assets they have in the pool.

 

Although AMMs have seen incredible growth in the last few months in the tens of billions, LPs often experience their staked tokens losing value compared to if they simply held it. LPs are people who stake their crypto assets in liquidity pools to earn passive income through other people’s trading fees. This occurs when your crypto asset changes value while in the liquidity pool, even if the value of your crypto increases! The more significant the price change is, the greater the impermanent loss becomes.

 

But if my crypto loses value, how is it impermanent? And Does it mean I can get the original value back?

 

Impermanent loss only becomes permanent when you withdraw your crypto assets from the pool, similar to how you only lose value on a spot trade if you sell at a loss. If your tokens return to their original value, then you are no longer at a loss.

 

With that out of the way, let’s tackle the most important part of the concept, why does it even occur in the first place?

 

In the world of online brokerages and exchanges, we’re used to the luxury of automatic and instant price changes. Unfortunately, AMMs are new and DEXes don’t operate the same way our traditional CEXes do. The price of an asset changes slowly with the help of arbitrageurs, who discover price differences in these markets and take advantage of arbitrage opportunities by buying an underpriced asset, or selling an overpriced asset.

 

Arbitrage is the simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset. This cycle repeats until the price within the AMM mirrors its value in outside markets.

 

To explain this more clearly, let’s look at an imaginary example using FLEX and USDC.

 

Let’s say 1 FLEX is the equivalent of 0.2 USDC. So, if you have a total of $200 in the pool to create an equal amount of crypto on both sides of the scale, the crypto would need to be split with 100 USDC valued at $100USD and 500 FLEX valued at $100 USD.

 

To understand how the LP would benefit by staking our crypto onto this pool, let’s now say the total liquidity of the pool is split 50:50 with 50,000 FLEX and 10,000 USDC.  We now own 1% of the pool and our LP token is therefore worth 1% of the pool and as a result we’ll receive 1% of the trading fees.

 

As more people hear about CoinFLEX’s incredible products such as its interest-bearing stable coins, physically delivered futures contracts, extremely low rates, and retail repo market, its name spreads rapidly amongst the crypto community and people flock to use CoinFLEX’s services. FLEX pumps and is now worth $0.40 instead of $0.20!

 

Remember though, the price of the asset in the pool does not react automatically and instead reacts manually, via the help of arbitrageurs who buy up the FLEX at the discount rate, until it’s value rises up to $0.40 and matches the rest of the market. A lot of USDC will be injected into the pool and a lot of FLEX will be extracted, balancing the scale. We can see that the ratio between assets determines the asset price.

 

Although this is advantageous to arbitrageurs, it comes at a cost to us. As an LP in the pool we are selling our FLEX even as it continues to appreciate in value. Our 500 FLEX has now decreased to 353 FLEX, and our 100 USDC has become 141 USDC.

 

If we are to withdraw our liquidity it would leave us with 353 FLEX ($141) + 141 USDC ($141) = $282

If we simply held our assets this would be 500 FLEX ($200) + 100 USDC ($100) = $300

This leaves us with an impermanent loss of $18 making it permanent if withdrawn. Note, however, that if the market for FLEX had fluctuated a lot before reaching $0.40 we may have collected more than $18 in trading fees leaving us at a net profit.

This graph describes the losses to LPs depending on the change in price of assets.

%E8%9E%A2%E5%B9%95%E6%88%AA%E5%9C%96 2021 06 16 %E4%B8%8B%E5%8D%8812.09.35 Demystifying Impermanent Loss

Reference: Impermanent Lossless AMM Model Using PostTrade Price https://ethresear.ch/t/impermanent-lossless-amm-model-using-posttrade-price/7896

 

Are there ways we can stop impermanent loss from happening?

Although we can’t stop it from happening, at least at this stage in AMM’s development, there are, however, strategies you can employ to reduce impermanent loss.

 

One strategy would be to provide liquidity to tokens that will remain within a similar price range. One pair example will be USDC and USD, which you can find at https://coinflex.com/amm. Both are stablecoins and are highly unlikely to range outside a price range of $0.99-$1.01. This would be a great opportunity to concentrate liquidity, which would make capital more efficient and minimise risk.

 

Another strategy could be farming coins during times of price consolidation, when the price of an asset fluctuates around a small margin. A perfect time to execute this strategy would be after our current bull and bear market, this could limit the amount of impermanent loss that occurs. As crypto is volatile this may only work for a few weeks or even days, and you would need to keep a steady eye on the market.

%E8%9E%A2%E5%B9%95%E6%88%AA%E5%9C%96 2021 06 16 %E4%B8%8B%E5%8D%8812.11.38 Demystifying Impermanent Loss

 

Finally, you can enter a liquidity pool with two tokens that perform similarly, so the ratio between them is similar. As both tokens grow proportionally, their ratio would stay the same or hover around 50:50, minimising the amount of impermanent loss. If you are secure in your decision to be a market maker, you would then need to calculate whether the profits you made through fees would be higher than the impermanent loss.

 

Conclusion

Despite the risk of impermanent loss, AMMs are a great way for passive earners to continue to make active income, by providing liquidity by facilitating trades to active traders and profiting off of fees.

 

The drawdown occurs when the price changes, which results in a loss of funds that become permanent if LPs remove their coins at a loss.

 

There are ways to prevent this however, such as providing liquidity to stablecoins, coins that grow in the same ratio, participating during quiet seasons of the Bitcoin cycle like after the bull and bear market occurs, or simply removing your coins once they return to their original ratio.

 

It is important for you to do your own research and familiarise yourself before providing liquidity, however once you are confident in your own abilities, you’ll be able to see it is a great way to earn passive income without worrying about getting stopped out.

Big Blocks and the Future of Payments

“I heard you say once That a lie is sweet in the beginning And bitter in the end And truth is bitter in the beginning And sweet in the end” A great quote from a song, most likely referring to controlled substances and meditation, but one that resonates with me…