What is Impermanent Loss in Crypto?

Impermanent loss (IL) is a risk faced by liquidity providers (LP) when some of their assets in a liquidity pool drop in quantity. That almost always leads to a decreased value compared to holding. Due to the ongoing rebalancing necessary to maintain a specific asset ratio set forth by automated market maker (AMM) algorithms, IL results from price fluctuations, which temporarily lowers the token value within a pool.

IL is termed "impermanent" because it is not realized unless the liquidity provider withdraws their assets from the pool. If the prices of the pooled assets return to their original state, the loss may be mitigated. However, if prices do not recover, the loss becomes permanent upon withdrawal.

Liquidity providers can earn trading fees and additional tokens, which can sometimes counterbalance the effects of IL. Nevertheless, the risk of IL is higher with more volatile cryptocurrencies, making it essential for LPs to carefully evaluate the potential risks before contributing to liquidity pools.

How Does Impermanent Loss Work?

Impermanent loss (IL) occurs when the value of assets provided to a liquidity pool changes due to price fluctuations, leading to a temporary decrease in the portfolio's value. Key aspects of IL include:

• AMM Algorithms: Automated market makers adjust the pool's ratios to maintain liquidity and facilitate trades. Note that a pool can consist of more than two assets and not have a balanced ratio (like Balancer's 80/20 pools).
• Adding Liquidity: An LP (the investor) contributes pairs of tokens like WETH and DAI to a liquidity pool on a DEX. The pool then utilized them for token swaps.
• Price Fluctuations: Changes in market prices cause the pool to rebalance, affecting the distribution of the provider's holdings.
• Arbitrage Opportunities: Arbitrage traders exploit price differences, altering the asset composition in the pool.
• Asset Redistribution: Providers often end up with more of the lower-value token and less of the higher-valued one—a mathematical drawback of AMMs.
• Temporary Nature: The loss is impermanent because it can reverse if prices return to their original levels.
• Realization of Loss: The impermanent loss becomes permanent when the user withdraws his assets at a loss.

How to Calculate Impermanent Loss

DeFi users can calculate impermanent losses manually, but it is tricky. First, you need to find the value of your assets if they are held in a wallet compared to their value in a liquidity pool after a price change. Then, you can calculate the IL using the formula from Figure 1 below. The price ratio is that of the token's price at withdrawal compared to when deposited.

Online calculators, such as those from CoinGecko, can simplify this process by considering initial crypto prices, pool composition, and price changes over time. A little-known fact, however, is that these IL calculators don't account for the yields that one might have gained LP-ing time. Therefore, a more complex calculator is needed, similar to THOR's yield calculator.

Examples of Impermanent Loss

Imagine a liquidity provider depositing equal values of ETH and DAI into a Uniswap pool. Initially, both assets are valued at $1,000 each (1 ETH at $1,000 and 1,000 DAI at $1), totaling $2,000. If ETH's price doubles while DAI remains stable, the pool rebalances to maintain the 50/50 value ratio, resulting in the provider holding less ETH and more DAI.

At this point, withdrawing from the pool would lead to an impermanent loss of approximately 5.7%.

How to Avoid Impermanent Loss in LP?

To minimize impermanent losses in liquidity pools, liquidity providers can implement several strategies:

• Stablecoin Pairs: Pools with stablecoin pairs eliminate price fluctuations. The most used stablecoins for LP right now are USDC and DAI.
• Single Asset Pools: Using single asset pools avoids the need to maintain a balanced ratio between multiple tokens (just staking ETH or yield farming USDC ensures a near-zero chance for IL).
• Diversification: Spread investments across multiple pools to mitigate the risks of any single asset's volatility.
• Timing and Monitoring: Provide liquidity during periods of low market volatility and regularly monitor asset prices to adjust positions as needed.
• Select Correlated Assets: Choose pools with assets that have strong correlations to decrease the chance of significant price divergences.
• Utilize Insurance and Hedging:  Look for DeFi platforms that offer features to protect against impermanent loss, such as compensatory token rewards and insurance-like structures like those provided by Bancor.

A quick tip: you can filter yield pools directly on DefiLlama for IL, stablecoins, and single exposure.

Bottom Line

Impermanent loss is a risk factor for DeFi liquidity providers resulting from changes in the relative value of assets in a pool due to market volatility or other nuances. Users mitigate the loss by holding assets until prices return to their original ratio, but they can also materialize it if withdrawals occur during big price disparities.

Providers can offset potential losses through strategies using stablecoin pairs, diversifying investments, and leveraging other IL protection tactics.