A lot of frictionless economic activity has been enabled by DeFi protocols like Uniswap, SushiSwap, and PancakeSwap. These protocols democratize the process of making trades and capturing trading fees.
In this article, we'll talk about one of the most important concepts you’ll need to understand if you want to provide liquidity for these platforms: impermanent loss.
Unsatisfactory impermanent loss is loss of money that doesn't create a financial deficit.
When you provide 2-way liquidity, you're at risk of impermanent loss. The amount of this loss correlates to the size and direction of asset price changes between deposit and withdrawal. In this scenario, a person stands to gain less in dollar terms than what they originally deposited.
If you want to avoid a permanent loss of value, pools containing assets that stay relatively in a small price range are best. For example, stablecoins or other types of cryptocurrencies wrapped in something different will stay relatively within a smaller range. In this case, the risk of permanent loss is minimized for liquidity providers (LPs).
One reason why liquidity providers will continue to provide liquidity is that impermanent losses can be countered with trading fees. The trading fees collected by pools on Unswap, for instance, can make those pools profitable.
For every trade that you make on our platform, Uniswap charges 0.3% of that fee to liquidity providers. This is why it's important for us to find good liquidity providers for the various pools since there will always be a lot of trading happening in any given pool. The amount you'll make with this strategy depends on your protocol, the specific pool, the deposited assets, and even wider market conditions.
How does loss happen?
If you own a liquidity provider, loss can make your life difficult. Let's take a look at an example of what that might entail.
Joe deposits 1 ETH and 100 DAI in a liquidity pool of equal value. This means that at the time of deposit, ETH is worth 100 DAI. It also means that at the time of deposit, Alice’s deposit (1 ETH + 100 DAI) is worth a total of 200 USD.
For example, Joe has 10% of the pool of 10 ADA and 1,000 USDC. That's 10% of a total liquidity of 10,000 in this case.
So, let's say for example that the price of ADA increases to 400 USDC. This creates two pricing issues. First, arbitrage traders will start pulling in USDC from the pool and removing ADA from it until the ratio reflects the current price. Second, AMMs don't have order books - they rely solely on supply and demand to determine prices and liquidity (10,000). As this happens, the ratio between assets in the pool changes.
The ratio of how much ETH is in the pool now compared to how much there was before is 4:1 and the ratio of DAI has also changed. There are now 5 ETH and 2,000 DAI in the pool thanks to arbitrage traders.
Joe wanted to withdraw his funds. As we learned from earlier, she would be entitled to a 10% share of the pool. As a result, he could withdraw 0.5 ADA and 200 USDC, totaling 400 USD. Since his deposit was worth 200 USD in tokens, he made some nice profit, right? But wait - what if instead she simply held 1 ADA and 100 USDC? The combined value of these holdings is currently 500 USD.
Alice would have been better off saving her initial investment rather than depositing it into the liquidity pool. This is because that loss is temporary, as it will eventually grow back to the original amount. In this case, Alice's loss was not a significant percentage of her original deposit. Still, remember that impermanent losses can lead to big losses (including a good chunk of your originally deposited money).
Joe's example ignores the trading fees that she would have earned by providing liquidity. In many cases, this would be more than enough to offset any losses and make providing liquidity profitable. However, it's still important to understand how to avoid short-term losses before trading through a decentralized finance protocol.
Permanent loss estimation
When the prices of assets in the pool change, this is impermanent loss. Let's plot that on a graph. Note that it doesn't account for fees earned when you provide liquidity.
This graph shows us the losses compared with HODLing - Do you think it's worth it?
1.25x price markup = 6% loss
For example, a price increase from $10 to $12 will result in a 25% loss
If the price of a product is changed by 1.75x, the associated loss will be 3.8%
A 2x price change means there will be a 5.7% loss
3x price change = -13.4% loss
Price change = 20.0% loss
5x price change = 25.5% loss
Although you're probably more concerned about potential gains, impermanent loss can happen no matter what happens. It only cares about the ratio of the price to the time of deposit. If you want to learn more about this, check out pintails article on the subject.
As a leading aggregator, we know the risks involved with providing liquidity to an artificial mattress manufacturer.
If you withdraw your coins from the liquidity pool, the losses become permanent. The fees may cover part of these losses, but they're still surprisingly misleading.
It's important to be extra careful when putting your hard-earned money into a liquidity pool. As we've discussed, some are more exposed to impermanent loss than others. Once you choose a pool, the more volatile the assets, the greater the chance for impermanent loss. It can also be best to start with a minimal amount to get an idea of what return you can expect before committing significantly more money.
One thing to look for is a more proven AMM. It's very easy for anyone to fork an AMM and make some small changes, but that can lead to some big problems. This may expose you to bugs and potentially leave your money stuck in the program forever. If an AMM seems too good to be true, it probably has some downsides-one of which is likely higher risk.
One way that AMMs provide liquidity to investors is by offering different types of investments. When an LP deposits assets into the fund, if the prices of those assets changes since then, he or she will be exposed to impermanent loss.