Just like fine wine and cheese, in the world of decentralized finance (DeFi), risks and rewards go hand in hand 🤌
One risk that liquidity providers must navigate is impermanent loss. In this blog, we will demystify impermanent loss, exploring what it really means, its impact on liquidity providers, and how to calculate it. We will also dive into strategies to mitigate impermanent loss and empower traders to make informed decisions in the dynamic DeFi landscape.
So, grab your popcorn and get ready for a thrilling DeFi adventure! 🍿
🤓 Key Takeaways:
- Impermanent loss is a loss that can occur when you provide liquidity to a liquidity pool 😅
- The amount of impermanent loss you experience will depend on the price change of the assets in the pool, the ratio of the assets in the pool, and the length of time you hold the assets in the pool 🔺
- There are a few things you can do to reduce the risk of impermanent loss such as staying patient or choosing less volatile assets 🧘♀️
- Impermanent loss is a temporary loss, and if the prices of the assets in the pool return to their original ratio, you will regain the value of your initial deposit 😎
🤔 What Even Is Impermanent Loss?
Picture impermanent loss as a mischievous rollercoaster gremlin that messes with your liquidity pool funds 🎢
When asset prices go on a wild ride, your overall portfolio value takes a dip compared to holding the assets separately. But don’t worry, it’s not a permanent loss! It’s more like a “temporary inconvenience” until the market regains its balance.
So, you just have to hold on tight and embrace the thrilling nature of impermanent loss! 🤞
Apart from your portfolio, this also occurs in liquidity pools, when the value of the assets in a liquidity pool changes relative to the value of the individual assets when they were deposited. This can happen if the price of one asset in the pool goes 🔺 or 🔻 more than the other asset.
😎 Let’s Take An Example And Calculate Impermanent Loss:
Calculating impermanent loss is like solving a fun puzzle with you as the detective. So, grab your magnifying glass (or calculator) and let’s get deducing!
Don’t let the math scare you! 😅
Imagine you are the sole investor in a newly established liquidity pool and you deposit the following assets 👇
- 💰 10 ETH with an initial value of $1,000 each
- 💰 $10,000 worth of a stablecoin equivalent, such as DAI (10,000 tokens)
👉 Suppose someone uses 500 DAI to purchase ETH from your pool. This transaction leads to a 5% increase in the supply of DAI.
As a consequence, the price of DAI decreases within the liquidity pool, while the price of ETH rises due to a reduction in its quantity.
This phenomenon is known as price impact, where each purchase elevates the price of the purchased token.
Subsequently, the AMM algorithm adjusts the prices of the tokens based on the updated quantities.
Liquidity pools often use a simple rule called the constant product formula. It multiplies the initial quantities of tokens in the pool, like 1,000 * 1,000 = 1 million. This 1 million value is then used to determine how prices change when people make trades and the token amounts in the pool shift.
👉 In this example, the formula relies on the starting quantities of 10,000 DAI and 10 ETH in the pool, resulting in a constant product of 100,000.
The following calculations explain how these figures were determined:
- ✖️ Constant Product: 100,000
- 💰 New DAI Supply: 10,500
- 💰 Remaining ETH Supply: 9.5238 (100,000 / 10,500)
- 💰 ETH Obtained by the Buyer: 0.04762 (10 – 9.5238)
Consequently, the updated pool supply is as follows:
- DAI: 10,500 * $1 = $10,500
- ETH: 9.5238 * $1,000 = $9,523.80
👉 Now, let’s say the price of ETH reaches a value of $1,250.
If you had held onto your original deposit, its worth would have been:
However, the remaining pool value differs:
Due to the swap, the number of ETH tokens decreased to 9.5238, resulting in an exchange value of $11,904.75 (9.5238 * $1,250).
Although the value of your DAI increased by $500, it was insufficient to avoid an impermanent loss. ❌
Consequently, following the swap, you experience an impermanent loss amounting to $95.25:
$22,404.75 (value after swaps) – $22,500 (value if held) = -$95.25 (impermanent loss) ❌
😏 How To Avoid Impermanent Loss?
When it comes to dodging impermanent loss, there are several strategies that can help reduce the risk and ensure a smoother crypto ride.
- Choose Low Volatility Tokens 💰 Opting for stablecoin pairs or equivalent tokens like ETH and WETH can be a smart move. These pairs typically experience lower price volatility, minimizing the chances of impermanent loss. In return for added safety, you might expect slightly lower fees.
- Join the Big League 😎 Size matters! Joining larger liquidity pools can work in your favour. These pools are better equipped to handle significant swaps without causing drastic price impacts. By swimming with the big fish, you can navigate the waters of impermanent loss with greater ease.
- Patience is Key 🔑 Sometimes, patience pays off. If you’re providing liquidity for high-demand tokens on a bustling platform, your impermanent loss may be temporary.
- Shake Up the Liquidity Ratio ⚡️ Some protocols offer the flexibility to choose a token ratio other than the traditional 50/50. Adjusting the ratio by allocating a lower percentage to more volatile tokens can help mitigate the risk of impermanent loss. It’s like finding the perfect recipe that balances flavours just right.
- Set Your Trading Range 🔢 Uniswap comes to the rescue with a nifty feature that allows you to set a trading range for your position. Tighter trading ranges offer increased safety but may require more frequent adjustments as prices fluctuate. It’s all about finding the sweet spot that suits your risk tolerance.
😌 In The End…
Impermanent loss, the mischievous troublemaker of liquidity pools, can be tamed with a sprinkle of fun. From low-volatility pairs to single-sided liquidity pools, there are tricks to reduce this risk.
- Start small 💰
- Learn from the data 🤓
- Gradually expand your positions 🤯
Remember, no matter the amount, the math remains the same. But starting small adds an extra layer of safety. So, buckle up, and let’s conquer impermanent loss with a smile!
Happy investing, and may your liquidity journey be filled with laughter and victorious moments. Together, we’ll become liquidity legends! 🔥