Risks Understanding Impermanent Loss

Impermanent Loss

Impermanent loss is one of the most critical risks liquidity providers (LPs) face in decentralised finance (DeFi). Here, we look into an explanation of impermanent loss, why it occurs, its impact on liquidity providers, and strategies to mitigate its effects.

What is Impermanent Loss?

Impermanent loss refers to the reduction in value that liquidity providers experience when the price of the tokens in a liquidity pool changes compared to their price at the time of deposit. This loss is termed “impermanent” because it only becomes permanent if the LP withdraws funds from the pool when the price disparity exists.

How It Happens

• Liquidity pools rely on an automated market maker (AMM) mechanism, maintaining a constant ratio between the two tokens.

• If one token’s price rises or falls significantly relative to the other, the AMM adjusts the pool’s token quantities to maintain this ratio. This adjustment can lead to LPs holding more of the less valuable and less of the more valuable tokens.

Example: An LP deposits 2,000 ADA (worth $2,000) and 2,000 USDM into a pool when ADA is priced at $1. If ADA prices increase to $3, arbitrage traders adjust the pool by adding USDM and removing ADA to restore the price balance. The LP now holds fewer ADA and more USDM, which, when withdrawn, may be worth less than simply holding the original deposit outside the pool.

Why Does Impermanent Loss Matter?

• Erosion of Earnings While LPs earn trading fees and rewards, impermanent loss can offset or exceed these gains, making liquidity provisioning less profitable.

• Volatility Risk The risk is higher in pools with volatile token pairs, as significant price swings amplify the loss.

• Misunderstood Risk Many LPs underestimate or misunderstand impermanent loss, potentially leading to unexpected losses when withdrawing liquidity.

Factors Influencing Impermanent Loss

• Price Volatility Greater price changes between the paired tokens result in higher impermanent loss.

• Pool Composition Pools with stablecoins or closely correlated assets (e.g., USDM/DJED or ADA/oADA) experience lower impermanent loss due to minimal price divergence.

• Trading Volume High trading volumes generate more fees, which can offset the impact of impermanent loss.

• Duration The longer funds remain in the pool, the greater the likelihood of price divergence, though long-term trends may stabilise.

Strategies to Mitigate Impermanent Loss

• Choose Stable Pair Pools Liquidity pools with stablecoins or tightly correlated assets reduce price divergence risks, minimising impermanent loss.

• Diversify Liquidity Provision Spreading assets across multiple pools, including stable pools and high-reward pools, balances potential risks and returns.

• Monitor Price Movements Regularly track token prices and withdraw liquidity during favourable conditions to avoid losses.

• Leverage Incentive Programs Participate in pools with significant rewards or yield farming incentives to offset potential losses.

• Withdraw Early During High Volatility In highly volatile markets, withdrawing liquidity early can prevent larger losses if prices diverge.

Balancing Rewards with Risks

While impermanent loss is a genuine concern, it does not necessarily make liquidity provisioning unprofitable. LPs should focus on:

• High-Volume Pools: These generate substantial trading fees, which can mitigate impermanent loss.

• Incentivised Pools: Rewards like native tokens or additional yield can significantly enhance overall returns.

• Portfolio Strategy: Treat liquidity provisioning as part of a diversified investment strategy rather than an isolated activity.

Impermanent loss is unavoidable in liquidity provisioning on AMM-based DEXes but can be mitigated with informed strategies and careful pool selection.

By understanding how it occurs and using tools and techniques to manage risk, liquidity providers can maximise their rewards while minimising potential losses. With proper planning and monitoring, impermanent loss becomes a manageable challenge within the broader context of decentralised finance.