Impermanent Loss

In decentralized finance (DeFi), automated market makers (AMMs) like Uniswap and SushiSwap rely on liquidity pools to facilitate trading without traditional order books. Users, known as liquidity providers (LPs), supply these pools with pairs of assets (e.g., ETH and DAI) in equal value. Impermanent loss arises when the price of the deposited assets diverges from their initial value at the time of deposit. The more significant the price change, the greater the impermanent loss. This loss is termed "impermanent" because if the asset prices return to their original state, the loss diminishes, and the LP may break even or profit from accumulated fees. However, if an LP withdraws their assets while prices are still divergent, the loss becomes permanent.

💻 Impermanent Loss CalculationImpermanent loss can be quantified using the following formula:

IL = 2 * sqrt(P) / (1 + P) - 1

Where:

• P = New price / Original price

For example, if the price of an asset doubles (P = 2), the impermanent loss would be approximately 5.7%. This means the value of the LP's assets in the pool would be 5.7% less than if they had simply held the assets without providing liquidity.

🏛 Example: Impermanent Loss in PracticeSuppose an LP deposits 1 ETH (worth $1,000) and 1,000 DAI (worth $1,000) into a liquidity pool, totaling $2,000. If the price of ETH increases to $2,000, arbitrage traders will adjust the pool's asset ratio to reflect the new price. As a result, the LP might end up with approximately 0.707 ETH and 1,414 DAI when they withdraw. The total value would be $2,828, but if the LP had simply held onto their original assets, they would have $3,000. The $172 difference represents the impermanent loss.

📚 References

1. Binance Academy – Impermanent Loss Explained
2. Kraken – What is Impermanent Loss?

⚠️ Controversies & Misconceptions

• "Impermanent loss means losing all your funds": Impermanent loss refers to a relative loss compared to holding assets outside the pool; it doesn't mean a total loss of funds.
• "Providing liquidity is always unprofitable due to impermanent loss": Trading fees earned from the pool can offset impermanent losses, and in some cases, make liquidity provision profitable.

🚀 Conclusion

Impermanent loss is a crucial concept for liquidity providers in DeFi platforms. Understanding its mechanics helps in making informed decisions about participating in liquidity pools and assessing potential risks and rewards.