In fact, even pools on Uniswap that are quite exposed to impermanent loss can be profitable thanks to the trading fees. However, if the funds are withdrawn from the liquidity pool before the assets’ prices return to their original levels, the impermanent loss becomes permanent. Therefore, the timing of withdrawal significantly impacts whether the impermanent loss is realized or not. In conclusion, impermanent loss is an inherent risk in DeFi liquidity provision, stemming from price divergence in pooled assets. When LPs provide assets to a liquidity pool, they essentially supply liquidity to the exchange.
If at any point the price ratio between the crypto pair reverts to its original ratio, the impermanent loss will disappear. We’ve ignored any potential profits you might have made from your share of the pool’s trading fees. In fact, in some scenarios, it’s possible to lose some or much of your original deposit. But what would have happened had you just sat on your initial crypto (HODLed it) without putting it to work for you?
It occurs when the price of one asset in a liquidity pool changes relative to the other assets. Therefore, it’s essential to understand how impermanent loss happens so that traders and LPs can make informed decisions when participating in liquidity pools. The greater a token’s share of a pool, the smaller the difference in outcomes between holding a token and providing liquidity in that token. In traditional financial markets, market makers provide liquidity by being ready to buy and sell assets at posted prices.
IL is not a reason to avoid LPing; it is just a cost that comes with earning the additional rewards. Crypto economic systems require large reserves of cryptocurrencies to seamlessly enable individual trades. Liquidity is provided by users (known as Liquidity providers, or LPs) to create these reserves. A low transaction fee is applied to each transaction within the pool, which goes straight to liquidity providers as rewards for their deposits.
However, because the protocol has automatically adjusted the amount of tokens held in the pool, you lost out on the CAKE rally. To overcome this limitation, platforms such as Balancer offer pools with different weights and a variable number of assets. For instance, one of the most popular pools on Balancer is BAL-ETH, where the weight of the BAL side of the pool is 80%. This means that changes in the price of ETH (positive or negative) will not affect the pool that much compared to a 50/50 split.
Several informative articles elucidate the concept and offer examples, yet they consistently present a formula for impermanent loss without providing its derivation. Furthermore, XION transactions will be gasless, streamlining the user experience. Get started with fast transfers and low fees from any EVM-based network. Understanding Impermanent Loss is necessary for any user of AMM platforms. You can make your own IL calculations using the calculator at dailydefi.org (based on Uniswap formulas).
This loss is impermanent because no loss happens if the cryptocurrencies can return to the price (i.e., the same price when they were deposited on the AMM). And also, liquidity providers receive 100% of the trading fees that offset the risk exposure to impermanent loss. Impermanent loss is a unique risk involved with providing liquidity to dual-asset pools in DeFi protocols. It is the difference in value between depositing 2 cryptocurrency assets within an Automated Market Maker-based liquidity pool or simply holding them in a cryptocurrency wallet.
Though, it is important to remember that your return is calculated after collecting fees. So even if unequal price fluctuations cause impermanent loss, you may still be able to make a profit if rewards from transaction fees cover the difference. Now that you have attracted enough liquidity providers, traders can start swapping tokens. But unlike CEXs, traders can’t toggle between their preferred token or currency in a single pool.
Essentially, it functions as a pool of funds comprising the assets you aim to trade for, facilitated by smart contracts, and each transaction within the pool incurs a tax. It represents the potential disparity in gains compared to simply holding the assets. The extent of impermanent loss exposure depends on the magnitude of price changes in the pool. The key is weighing the opportunity costs of HODLing assets individually vs. LPing them to earn extra rewards at the expense of impermanent loss. If the liquidity rewards outweigh the IL potential, then why would a user not participate in liquidity provision?
17.179 DAI, or about 5.72%, is what we would have gained if we simply held the assets instead of staking them in the pool. It is important to note that we have still gained on our initial position of 200 DAI, but in this simple example, the optimal thing would have been to hold the assets. As we can see the LP would’ve had $23.41 more if they just held their assets without providing liquidity. So, impermanent loss happens when the ratio between the two assets in the pool changes.
The number of liquidity providers and tokens in the liquidity pool determines the level of impermanent loss risk. Uniswap charges 0.3% on every trade that directly goes to liquidity providers. If there’s a lot of trading volume happening in a given pool, it can be profitable to provide liquidity even if the pool is heavily exposed to impermanent loss. This, however, depends on the protocol, the specific pool, the deposited assets, and even wider market conditions.
With it, liquidity providers can get the exact data needed to evaluate IL risk for token pairs in specific liquidity pools on different DEXs. Despite the presence of impermanent loss, trading fees can act as a countermeasure to reduce its impact. The amount of impermanent loss can also be impacted by the tokens in the liquidity pool as well as the number of liquidity providers in the pool. Since the above examples uses an ETH/USDC liquidity pool, ETH has a stable asset to swap against.
- While yield farming is more profitable than holding, offering liquidity has its risks, including liquidation, control and price risks.
- Remember, DeFi exchanges don’t rely on external markets setting the price for token valuation.
- Uniswap charges 0.3% on every trade that directly goes to liquidity providers.
- By effectively managing these factors, you can potentially achieve attractive returns while mitigating the impact of impermanent losses.
While liquidity remains constant in the pool (10,000), the ratio of the assets in it changes. A month later, ETH doubled in value while BTC’s price stayed the same. But the value of both token baskets in the pool don’t yet reflect the ETH market-wide price of .2 BTC. So arbitrage traders rush in to buy ETH at the discount until the pool ratio and token prices match the market rate. Arbitrage traders would then take that opportunity to buy BTC at a discount and sell it for ETH in the liquidity pool. This arbitrage would continue until the price falls back to market rates.