In this article, I will briefly explain what Impermanent Loss means and how this phenomenon can affect the profit of liquidity providers.
How Do We Characterize Impermanent Loss?
This concept reflects the temporary loss of a part of the liquidity owned.
The phenomenon occurs within liquidity pools, where the liquidity provider must include proportional amounts of 2 different tokens.
If one of the tokens is more requested, then the proportion of the two assets in the pool changes.
In case the provider now decides to withdraw their assets from the liquidity pool, they risk not recovering the entire amount and in the proportion in which they have deposited it.
Practical Case of Impermanent Loss – How Two Assets Equate in a Pool
To support the funds of an AMM, person X deposits 1 ETH and 100 DAI in a liquidity pool at a 50/50 ratio.
The amounts of the deposited tokens must have an equivalent value.
In the case described, this means that the price of 1 ETH is 100 DAI at deposit time.
Also, let’s say that the current dollar value of person X’s deposit is $200.
If the total in that pool (also supported by other providers) is 10 ETH and 1,000 DAI, person X holds a 10% share of the fund, and the total liquidity is 10,000.
How Does Impermanent Loss Occur?
In this case, let’s suppose that the ETH price increases to 400 DAI.
If this happens, arbitrage trading strategies will add DAI to the pool and remove ETH until the ratio reflects the current price.
Since AMMs don’t work with order books, the price of the assets is given by their ratio in the pool.
In short, if the liquidity remains constant in the fund (10,000), the ratio of the assets in it changes.
How Many Funds Does the Provider Get?
If ETH has come to be 400 DAI, the ratio of the existing ETH and DAI amounts in the pool has changed.
There are now 5 ETH and 2,000 DAI in common, but if person X decides to withdraw their funds, they are entitled to 10% of that pool.
So, they can only withdraw 0.5 ETH and 200 DAI, totaling $400.
Although profits of $200 resulted, the amount would have been different if they had continued to hold 1 ETH and 100 DAI.
The combined dollar value of these assets would now have been $500.
The loss was not substantial, as the original deposit was a relatively small amount.
In other circumstances, the impermanent loss may result in the loss of a significant part of the original deposit.
Our example completely ignores the trading fees that the provider would have earned.
In many cases, the earned fees can cancel losses and make supplying liquidity profitable.
It is crucial to understand the concept before providing liquidity to a DeFi protocol.