What is Impermanent Loss
Impermanent loss refers to the temporary loss of funds that occurs when providing liquidity to a decentralized exchange (DEX) or automated market maker (AMM). This phenomenon arises when the price of the assets deposited in a liquidity pool diverges from their original price at the time of deposit. The term was first coined in the context of DeFi (Decentralized Finance) to describe the opportunity cost faced by liquidity providers who may have been better off simply holding their assets instead of providing liquidity.
The concept is crucial for understanding the risks involved in liquidity provision, especially in volatile markets. When liquidity providers deposit tokens into a pool, they receive liquidity tokens in return, which represent their share of the pool. If the price of the tokens changes significantly during the period they are locked in the pool, the liquidity provider may suffer a loss compared to simply holding the tokens. This loss is termed "impermanent" because it can be reversed if the prices return to their original state.
What are the types of Impermanent Loss?
Impermanent loss can manifest in various forms, depending on the market conditions and the assets involved. The primary types include:
Price Divergence: This occurs when the price of the assets in the pool changes significantly, leading to a mismatch in their initial value compared to their current value.
Volatility: High volatility in the asset prices can exacerbate impermanent loss, as rapid price changes increase the likelihood of divergence.
Token Pairing: Different pairs of tokens can experience varying degrees of impermanent loss based on their historical price correlation and market behavior.
How does Impermanent Loss work?
Impermanent loss occurs when a liquidity provider deposits two assets into a pool, such as ETH and USDC, at a 50/50 ratio. If the price of ETH increases significantly after the deposit, the DEX's automated market maker will adjust the ratios of the tokens in the pool to maintain the 50/50 balance. As a result, the liquidity provider would end up with less ETH and more USDC than they initially deposited.
To quantify this, if a liquidity provider deposited 1 ETH (worth $2,000) and $2,000 in USDC, they would hold 1 ETH and $2,000 in USDC. If the price of ETH rises to $4,000, the provider might find they now hold 0.5 ETH and $4,000 in USDC instead of simply holding 1 ETH, resulting in an impermanent loss of $1,000 compared to just holding the ETH.
This loss is termed "impermanent" because if the price of ETH drops back to $2,000, the provider's assets would revert to their original value, negating the loss. However, if they withdraw their funds while the price is still above the original level, the loss becomes permanent.
Where is Impermanent Loss found?
Uniswap V3: Liquidity providers can experience impermanent loss when providing liquidity in concentrated ranges, with an estimated average impermanent loss of around 10% during high volatility periods.
SushiSwap: In a recent analysis, liquidity providers experienced impermanent losses of up to $2,500 when ETH prices surged by 40% over a week.
PancakeSwap: Users providing liquidity for the BNB/BUSD pair noted an average impermanent loss of approximately 15% during significant market fluctuations in Q1 2023.
