What is impermanent loss?
Impermanent loss is a risk that occurs when participating in DeFi liquidity pools, where the value of your allocated assets changes from the time you allocated them.
This loss is termed 'impermanent' because it can be mitigated if the token price returns to its original value.
While impermanent loss presents risks, providing liquidity also provides rewards through trading fees and additional tokens.
Understanding Impermanent Loss
Impermanent loss refers to a situation where the compensation you receive from allocating a token in a liquidity pool is less than what you would have received just holding the asset. This happens when a token’s price changes in the market, causing your allocated assets in the liquidity pool to become worth less than their present value in the market. The larger this price change, the more your assets are exposed to impermanent loss.
For instance, if the value of the assets in the pool changes significantly, the user may experience impermanent loss. This gap is “impermanent” because it is possible to close the gap if the token price returns to the former price.
How Does Impermanent Loss Work?
Impermanent loss does not necessarily prevent liquidity providers from receiving compensation. This loss is only tangible if investors withdraw their liquidity from the pool at that exact moment in time. Often, pools employ strategies to offset this loss, such as charging high fees. Therefore, liquidity providers receive more from fees to cover their impermanent loss.
However, in case of a considerable price difference, your fee compensation might not cover the loss. In this case, you would have gained more value if you held the assets instead of providing liquidity.
Calculating Impermanent Loss
Calculating your exact loss might be a little tricky due to the complexity of some of its variables. But you can estimate your loss with the formula below:
Impermanent Loss = 2 * sqrt(price_ratio) / (1+price_ratio) – 1
The price ratio is the ratio between the token price at allocation and withdrawal.
Managing Impermanent Loss
While you can’t avoid impermanent loss, you can reduce exposure. Here are some tips to help:
The more volatile the assets, the more impermanent loss is likely to occur. Use more stable tokens like stablecoins or BTC to reduce the chance of impermanent loss.
Ensure you also use tried and tested Automated Market Makers to reduce your exposure to market manipulation.
Start by allocating a small amount to diversify your portfolio and reduce the percentage of your assets exposed to impermanent loss.
Impermanent Loss Protection
Impermanent Loss Protection (ILP) is a type of insurance that protects liquidity providers from unexpected losses. Liquidity provisioning is only beneficial on typical AMMs if the benefits of farming surpass the cost of temporary loss. However, if the liquidity providers suffer losses, they can utilize ILP to protect themselves against impermanent loss. To activate ILP, tokens must be allocated on a farm.
