Impermanent Loss

What Is Impermanent Loss?

Impermanent loss occurs when the value of assets you’ve deposited in a liquidity pool changes compared to holding the assets in a personal wallet. This change can lead to a lower dollar value when you withdraw your assets, even if the number of tokens remains the same.

What Does Impermanent Loss Mean in the Crypto World?

In the crypto world, impermanent loss is a risk faced by liquidity providers in decentralized finance (DeFi). When you add liquidity to a pool, you might earn fees and rewards. However, if the prices of the assets in the pool change, the value of your share in the pool can be less than if you simply held the assets in a wallet. The term "impermanent" suggests that the loss is not locked in until you withdraw your funds. If the asset prices return to their original state, the loss can be reversed.

How to Use the Term

You can use the term "impermanent loss" to describe the potential downside of providing liquidity in DeFi platforms. For example, "As a liquidity provider, you should be aware of impermanent loss, which can affect your returns when asset prices fluctuate."

Example of Impermanent Loss

Suppose you decide to provide liquidity to an Ethereum/Bitcoin (ETH/BTC) liquidity pool. You deposit an equal value of ETH and BTC into the pool. Let's say:

• You deposit 1 ETH (worth $2,000) and 0.1 BTC (also worth $2,000) into the pool.
• The total value of your deposit is $4,000.

Initial Pool State:

• 1 ETH = $2,000
• 0.1 BTC = $2,000

Now, imagine that the price of ETH increases significantly, and 1 ETH is now worth $3,000, while BTC remains at the same price.

New Market Prices:

• 1 ETH = $3,000
• 0.1 BTC = $2,000

Impact on the Liquidity Pool

Due to the price change, arbitrage traders will trade ETH for BTC in the pool until the pool reflects the new market ratio. This trading changes the ratio of ETH and BTC in the pool.

New Pool Ratio

Let's assume the pool now holds 0.866 ETH and 0.133 BTC, reflecting the new price ratio after arbitrage trades.

Withdraw Your Assets

When you withdraw your assets, you receive a new ratio of tokens based on your share of the pool. You might get:

• 0.866 ETH (worth $2,598)
• 0.133 BTC (worth $2,660)

Total Value of Withdrawn Assets: $5,258

Compare to Holding

If you had simply held your original assets (1 ETH and 0.1 BTC), their combined value with the new prices would be:

• 1 ETH (worth $3,000)
• 0.1 BTC (worth $2,000)

Total Value If Held: $5,000

Calculating Impermanent Loss

In this scenario, providing liquidity earned you a total value of $5,258, compared to holding, which would have resulted in $5,000. However, this example doesn't show a loss but a potential difference due to impermanent loss can be a disadvantage compared to simply holding the assets.

While you earned more in this scenario, the value change due to impermanent loss is a key factor to consider, especially when the changes are adverse. Trading fees earned as a liquidity provider can help offset these losses, which is why many investors remain in pools for extended periods.