The decentralized finance (DeFi) ecosystem offers crypto holders a variety of resources and strategies to make the most of their digital asset holdings. Liquidity pools, which are used to facilitate decentralized crypto trading, lending, and more, are one of the most widely used elements of the DeFi economy.
Understanding the risks associated with committing assets to a liquidity pool is an important element of due diligence and risk management in DeFi. One of the most important factors to consider when participating in a liquidity pool is impermanent loss.
This article provides an explanation of how impermanent loss works, how to avoid impermanent loss, and a short summary of the risks associated with providing liquidity within the DeFi economy.
What is impermanent loss?
Impermanent loss is a unique risk associated with contributing assets to liquidity pools. Impermanent loss happens when the price of an asset changes after the asset has been committed to a liquidity pool, and occurs specifically within dual-asset liquidity pools.
Many liquidity pools offer participants significantly higher returns than those offered by traditional financial institutions. While liquidity pools may offer higher annual percentage yields than traditional finance equivalents, they can present complex risks that must be carefully considered.
Impermanent loss occurs when the price of an asset committed to a liquidity pool changes compared to the price of the asset when it was committed to the pool. The size of the loss within this context is equivalent to the size of the change in asset price between when it was committed to the liquidity pool and when it is withdrawn.
Impermanent loss can appear complex at first glance — a liquidity pool participant may not actually lose any money, but may lose potential gains should they have not committed assets to a liquidity pool at all. Impermanent losses may disappear or be amplified depending on market movements.
It is called “impermanent loss” because the loss is not realised until a liquidity provider withdraws assets from a liquidity pool.
How does impermanent loss work?
Impermanent loss is caused by the need to maintain a balance between the assets that make up a liquidity pool. Liquidity providers receive tokens that represent the percentage of liquidity they have committed to a pool when they supply liquidity. These tokens, referred to as liquidity provider tokens, or LP tokens, are used to redeem the assets when withdrawn.
Sometimes, when a pool is rebalanced to maintain a 1:1 ratio, the LP tokens a liquidity provider possesses might entitle them to less value than originally committed, due to price changes in the assets that make up the pool. This is the core of impermanent loss. However, this “loss” may change if the pool rebalances in a manner favourable to the liquidity provider.
Changes to the balance of digital assets within a liquidity pool combined with asset price changes can dilute the value of liquidity provider tokens.
Example of impermanent loss
Freya wants to commit assets to a dual-asset liquidity pool composed of ETH and DAI. To do so she deposits assets in equal value, $100 worth of ETH and $100 worth of DAI. She then receives liquidity provider tokens (LP) that entitle her to a specific percentage of the pool equivalent to the amount of liquidity she has committed (in comparison to total pool liquidity).
In this scenario, Freya commits $100 worth of ETH and $100 worth of DAI to a liquidity pool, bringing the total liquidity of the pool up to $1,000 worth of assets. Therefore, Freya’s LP tokens represent 20% of the pool — $200. Should Fryea wish to withdraw her assets from the pool at a later date, the LP tokens she possesses entitle her to withdraw 20% of the total liquidity in the pool.
If other investors contribute to the pool after Freya’s contribution, the percentage value of her LP tokens decreases. They are still entitled to the same value of digital assets originally committed but are entitled to a smaller percentage of the pool. For example, if the total pool liquidity increases to $2,000, her share would decrease to 10%.
Did You Know?
Dual-asset liquidity pools must remain balanced (most commonly at a 1:1 ratio). For example, an ETH/DAI liquidity pool with a total value of $10 million must be composed of $5 million worth of ETH, and $5 million worth of DAI, regardless of the total amount of tokens of each asset required to maintain this balance.
How liquidity pool asset balance affects impermanent loss
When the value of the assets in a pool changes, the balance of tokens within the pool changes accordingly. Liquidity pools consist of assets committed by many investors — as these investors contribute and withdraw assets from the pool, the number of tokens of each individual asset on either side of the pool may expand or contract.
Imbalance within liquidity pools provides arbitrageurs with the opportunity to purchase assets at a lower price when compared to the broader digital asset market. Arbitrage traders perform a critical function within automated market maker (AMM) mechanisms and balance liquidity pools, but can negatively impact liquidity providers.
Should this scenario occur in the ETH/DAI liquidity pool outlined above, Freya — who is entitled to a 20% share of the pool and not a specific dollar value — may receive a different ratio of assets than she originally deposited.
This ratio can significantly impact the dollar value of the assets withdrawn from a pool. Say arbitrageurs rebalance a pool in order to meet broader market price movements. This might result in an unfavorable distribution of assets compared to the prices at the time the assets were committed. Therefore, the investor may generate a loss compared to the potential gains of never committing assets to the pool at all.
Important To Remember
While impermanent losses can represent significant value, the scenario outlined above does not take into account the trading fees an investor earns by committing assets to a liquidity pool. In some cases, trading fees paid to liquidity providers can negate impermanent losses and generate profit for investors regardless of asset ratio changes.
Crypto liquidity pools are generally composed of two different assets referred to as a pair, such as the ETH:DAI pool from the example above. These assets are usually balanced equally in order to establish an automated means for traders to exchange assets.
Liquidity pools balanced in this manner allow AMMs to facilitate the exchange of assets without requiring counterparties, which are required in traditional order book-based cryptocurrency exchanges. Traders use liquidity pools to access permanently available liquidity for the trading pairs they wish to exchange.
Automated market makers (AMMs)
Automated market makers (AMMs) govern the composition of liquidity pools and are responsible for calculating the initial exchange price within a pool and automatically raising or lowering the value and ratio of assets within a pool.
How do I avoid impermanent loss?
Impermanent loss is virtually impossible to avoid when committing digital assets to a balanced liquidity pool due to the inherently volatile nature of the crypto market. The market prices of digital assets constantly change, which requires ongoing asset ratio rebalancing within liquidity pools.
There are, however, a number of factors that can mitigate the impact of impermanent loss.
Low volatility pairs
The impact of impermanent loss can be mitigated by committing assets to liquidity pools that are comprised of assets with less volatile exchange prices.
Some examples are stablecoin pairs, such as DAI:USDT. Variations of the same blockchain token can present a lower volatility risk. Wrapped tokens that link the price of one digital asset to another, or another type of asset —such as wETH:ETH pairs, which tracks the price of ETH — also represent a lower volatility risk when compared to other digital asset pairs.
Committing assets to liquidity pools composed of less volatile assets reduces the likelihood of significant price movements, minimizing the impact of impermanent loss.
Complex liquidity pools
The 1:1 balance of most dual-asset liquidity pools is a primary contributing factor to impermanent loss. Some decentralized exchanges or DeFi protocols offer a wide range of liquidity pool ratios, such as complex or multi-asset liquidity pools that are composed of more than two assets.
Complex liquidity pools can include pools that operate with higher ratios, such as asset distributions of 80:20 or 98:2. Higher asset ratio pools are less likely to cause impermanent loss when compared to equally balanced pools.
One-sided liquidity pools
Some decentralized exchanges offer unique liquidity pools that provide investors with the option to commit assets to a single side of an asset pair. By eliminating the need for investors to commit assets to both sides of an asset pair, one-sided liquidity pools work to eliminate the risk of impermanent loss.
The example scenario outlined earlier did not account for the trading fee rewards associated with a liquidity pool. Liquidity pools collect trading fees from traders that exchange assets through the pool, then distribute them to liquidity providers in proportion to their contribution to pool liquidity.
In many cases, the fees generated by a liquidity pool are of sufficient value to offset and mitigate impermanent losses. The impact of impermanent losses decreases in proportion to the increase of trading fees within a pool. Should a liquidity pool collect a sufficient amount of trading fees, an investor that contributes assets to the pool will gain more than they would have should they not have contributed their assets.
What are the risks of providing liquidity to an AMM?
Impermanent loss is named as such due to the fact that losses are not realised until an investor withdraws assets from a liquidity pool. Upon withdrawal, however, impermanent losses become real losses. While trading fees distributed by liquidity pools may mitigate or, in some cases, entirely offset impermanent losses, investors should perform careful due diligence before they provide liquidity to an AMM.
As outlined above, liquidity pools that consist of volatile asset pairs present a higher risk of impermanent loss when compared to less volatile pairs. It’s important to note that large price movements in the price of the assets that make up a liquidity pool can increase impermanent loss.
Impermanent loss is a critical risk factor that must be taken into careful consideration before contributing assets to liquidity pools. Should the price of an asset change after liquidity is committed to a pool, the liquidity provider may be subject to impermanent loss and can lose money. This article has outlined how impermanent loss works and how to mitigate the risks associated so you can make the most informed decisions with your crypto investments.