What Is Impermanent Loss?

The following topics will be discussed in this article: What is Impermanent Loss?. Examples of impermanent loss. Impermanent loss, The impermanent loss calculator, and how to avoid the impermanent loss.

When a liquidity provider suffers a momentary loss of funds due to the fluctuation in a trading pair, this is known as an impermanent loss.

Defintion Impermanent Loss

As the name implies, Impermanent loss refers to the temporary loss of funds that liquidity suppliers may face due to volatility in a trading pair.

It also shows how much more income someone would have. If they had decided to keep their possessions rather than give capital reserves.

While one of the assets in a liquidity pool may be a stablecoin like DAI, the other may be a more unstable digital currency like Ethereum.

Let’s say a supplier needs to supply comparable levels of liquidity. Both in DAI and ETH, but the cost of ETH unexpectedly rises.

Because the price of ETH in the liquidity pool no longer reflects what’s going on in the real world. This presents an appealing opportunity for profit. Other dealers will buy ETH at a discounted rate until the ratio of DAI to ETH is restored, ensuring that the ratio stays fair.

A liquidity provider may eventually wind up with more DAI and somewhat less ETH as a result of arbitrage. The present price of their possessions is compared to what they would be valued if they were left alone in a transaction.

Only when a supplier chooses to permanently remove their liquidity does the loss become irreversible.

Liquidity Pools And Automated Market Makers

A technique known as an automated market maker is used by distributed trades. This is to enable any token holder to invest their tokens into a liquidity pool. The token combination is generally based on Ethereum and a stablecoin such as DAI.

Therefore, if a trader wants to exchange Eth for DAI, they may go to the pool, deposit some ETH, and receive the corresponding DAI, without a transfer charge (0.3 per cent.) The people who have invested in the pool, dubbed liquidity suppliers, will be paid the service charge.

A 50/50 split in the value of both tokens is required in a liquidity pool. DAI, for example, is tied to the US dollar, which means that 1 DAI is always $1. There must be 1000 DAI in the pool if one ETH is worth 100 DAI and there are ten ETH in the pool. Also, keep in mind that the token prices in this pool are solely influenced by the ratio between them, not by market pricing.

You must put an equivalent amount in value for both tokens. When depositing into a pool. So, if you wish to risk 1 ETH, you’ll also need 100 DAI. After your deposit, assuming the entire pool holds 10 ETH and 1000 DAI, your proportion is 10%.

Should you elect to withdraw, you will receive 10% of the total transaction costs (0.3%) paid up to that time. Assume the ETH prices stay unchanged and there were 100 ETH in transaction volumes prior to your withdrawal. The liquid vendors would gain 0.3 ETH as a function of this.

Keep in mind that the value of ETH and DAI must always be equal, therefore 0.3 ETH equals 0.15 ETH and 15 DAI. There are presently 10.15 ETH and 1,015 DAI in the liquidity pool. You’ve made a profit with a 10% stake at this stage.

What Causes Impermanent Loss?

But now we see how liquidity providers profit in the ideal circumstance where prices are a tranquil candlestick. Volatility is unavoidable in the crypto world, and prices fluctuate frequently.

When the price of your token fluctuates after you put it in the liquidity pool, you suffer a transitory deficit (impermanent loss)

If the price of ETH rises to $200, you’ll be looking at a 1 ETH to 200 DAI exchange rate.
At this time, you’ll understand that if you’d kept your 1 ETH and 100 DAI, you’d have made a profit of $100. However, because you deposited it in the liquidity pool, you’re locked with the initial price, resulting in a 50% temporary loss.
The good news is that this setback may just be brief. If ETH returns to its original price at the time of your deposit, you will have made a profit.

Now let us look at an example of how a liquidity provider could experience temporary loss.

In a liquidity pool, Lucy puts 1 ETH and 100 DAI. The deposited token pair must be of equal value in this automated market maker (AMM). This means that the cost of ETH at the time of deposit is 100 DAI. This also suggests that Lucy’s deposit was valued at $200 at the time of deposit.

There’s also a total of 10 ETH and 1,000 DAI in the pool, which is supported by other LPs like Alice. As a result, Lucy owns 10% of the pool, and the total liquidity is $10,000.

More Information On The Reasons For Impermanent Loss.

Consider the case where the price of ETH rises to 400 DAI. Arbitrage traders will add DAI to the pool and remove ETH from it while this is happening. Until the ratio represents the current price. Order books are not used by AMMs. The ratio between the assets in the pool influences the price of the assets in the pool. While the pool’s liquidity (10,000) remains constant, the asset ratio fluctuates.

The ratio between the amount of ETH and the amount of DAI in the pool has switched if ETH is now 400 DAI. Thanks to the efforts of arbitrage traders, the pool now has 5 ETH and 2,000 DAI.

As a result, Lucy chooses to withdraw her money. As previously stated, she is eligible to a 10% share of the pool. So, she can withdraw 400 USD in 0.5 ETH and 200 DAI. Isn’t she doing well since her initial deposit of 200 USD in tokens? But wait, what if she had just kept her 1 ETH and 100 DAI? The current market value of these assets is 500 dollars.

Lucy would have been better off HODLing rather than putting into the liquidity pool, as we can see. Impermanent loss is what we call it. Alice’s loss was not significant in this scenario because the initial deposit was quite little. However, keep in mind that a temporary loss might result in huge losses including a significant amount of the initial deposit.

Having said that, Lucy’s scenario ignores the transaction fees she would have received for providing liquidity. In many circumstances, the fees earned would offset the losses. Also making liquidity provisions beneficial. Even so, an understanding of impermanent loss is critical before supplying liquidity to a Defi protocol.

Points To Note

The trading fees you would have made along the road, regardless of temporary losses, were not factored into any of the calculations. Most people believe that the profits will eventually offset the price increases.

This may be true, but we are unable to cover our losses with our revenue.
As a result, only stake your tokens after careful deliberation, considering the risk estimates described before. Start small and only invest what you can afford to lose, as the larger your deposit, the greater the risk of a temporary loss when values fluctuate.

Looking beyond ephemeral loss is one of the most effective strategies to overcome it. The tokens you’ve pledged already have a purpose: to generate trading fees for you. Allow them to do their work because the more you put into the formula, the less you’ll receive back.

Impermanent Loss Estimation

Impermanent loss is dependent on sheet value, which means it can change until you act quickly. Your damage will become irreversible if you opt to withdraw following a change in price.

This is where things get fascinating since you’ll get a completely different figure than you expected. When the price of ETH rises, arbitrage traders have a window of opportunity to buy the token at a low price.
Because the new rate for ETH is 200 DAI and the previous price in the liquidity pool is 100, traders can substitute DAI for Ethereum until the ratio reflects the new rate. This ratio is calculated using a complicated formula, but you can find the precise value using a web calculator.

Note that your pool has 10 ETH and 1000 DAI. We can now calculate a new ratio by plugging in the new ETH price of 200 DAI into the calculator.

10 ETH/1000 DAI ⇒ 7.07 ETH/1,414.21 DAI.

The arbitrage traders got away with 2.93 ETH for 414 DAI, as you can see. On the other hand, you still own a 10% stake in the new ratio. If you withdraw 0.707 ETH x 200 + 141.421 DAI amounting to $282.

This really is still more than the $200 you began with, but you would have had $300 alternatively if you hadn’t deposited.

Meaning Of Impermanent Loss in Defi Yield Farming

Yield farming, a sort of investment in which you lend your tokens to gain rewards, is directly related to impermanent loss.

It may sound similar to staking, but it is more complicated. Yield farming entails borrowing your tokens to a liquidity pool or raising capital.

The incentives vary according to the methodology. Although yield farming is a more profitable option than holding, supplying liquidity comes with its own set of hazards.

The number of liquidity providers and the number of tokens in the liquidity pool define the level of danger of temporary loss. The token is coupled with another token, usually an Ethereum-based token and a stablecoin.

Because an ETH/DAI liquidity pool has a steady asset to exchange with – DAI – it has a lower chance of temporary loss than an ETH/SUSHI combination.

Because prices can always return to the initial exchange price in the future, the price change is referred to as an impermanent loss. If your asset is priced the same as the initial deposit price, the temporary loss is reversed.

If you take your funds from the liquidity pool, the loss becomes permanent.
But why is the market rate in a liquidity pool differ from the market rate on a platform like Coinbase?
Since they follow an automated market maker system, liquidity pools differ from exchanges. The price of assets is determined by algorithms in this market-making protocol.

A constant product money maker algorithm is used by basic liquidity pools like Uniswap.
Liquidity pools, unlike other investment choices such as time deposits, allow you to trade your assets out at any time, even if buyer and seller orders do not match.

Furthermore, the ratio between assets in liquidity pools influences their prices, not the prices on external markets.

As a result, any change in this ratio must be carefully evaluated. This is to ensure that the value of both pool assets remains constant. Otherwise, the move could result in a considerable price difference from their current price on a traditional order book-based exchange.

If this is too difficult for you, don’t worry; we’ll present an impermanent loss calculator in the next part that will allow you to quickly compute the impermanent loss.

Is there any way to make up for this loss? Without adequate incentives from trading costs and other protocol-specific incentives, it is difficult to totally eliminate an impermanent Loss.

There are, however, numerous techniques to reduce the losses.

We’ll lead you through certain scenarios of liquidity pool impermanent loss, how to calculate it, and how to avoid it altogether by the end of this tutorial.

Calculator For Impermanent Loss

If you have a concept of how your assets in the liquidity pool will flow in the foreseeable. Then you can estimate how much impermanent loss to expect. An Impermanent Loss Calculator can be used to predict the quantity of impermanent loss in advance.

The calculator works by entering the starting and future prices for your two assets. This calculator employs the constant product formula, which keeps the two assets in a 50/50 split. Follow this two-step procedure:

  1. Fill in the starting prices, which should reflect the prices of both assets at the moment of deposit.
  2. Fill in the future prices. These could be the current or expected asset prices at the time of the scheduled pullout.

We calculate an asset with the ratio between asset values in liquidity pools in the example below, which is a stablecoin. Therefore it stays at $1. The temporary loss at that price movement, according to the calculator, is 1.03 per cent.

The calc also illustrates how actual values could be used to calculate this price change. For example, the calculator displays the cost of holding each asset for US$500 and the cost of withdrawing both assets from the liquidity pool.

If you’re thinking about putting your tokens into a liquidity pool, an Impermanent Loss Calculator can help you figure out how much risk you’re taking.

We’ll look at how this calculator works and how the formula was created in the next part.

Calculating Impermanent Loss

After you’ve seen what an Impermanent Loss Calculator can do, you’ll want to understand how it works. This impermanent loss formula can be used to calculate:

The variable k in this calculation represents the change ratio from the initial to the final price. For example, if the value of an asset increases by 10%, k becomes 1.1.
You can multiply the % by the original value to find the actual dollar amount once you have the value of temporary loss for the specified change k.
If my impermanent loss is 0.6 per cent and my asset’s original price is US$1000, my actual liquidity pool impermanent loss is US$1000 * 0.6 per cent = US$6.

This IL calculator is very easy to use. Just select the complexity option (Simplest, Simple or Advanced), input your token data, and view the results. Using this calculator, you can start to understand how liquidity pools work.

To begin, you need to be aware of the following:

The concept of impermanent loss is difficult to grasp. It’s normal to be confused or overwhelmed by the concept at first.

Watch the tutorial video and understand how to utilize the tool above. You can start with the Simplest tab. To calculate the total impermanent loss, multiply the percentage change of token A by the percentage change of token B.

The Simple tab, which contains four inputs, is next. Begin with Token A, by entering the starting and ending prices. Continue with Token B in the same manner. The calculator will calculate the percentage change and use it to calculate the situation’s temporary loss.

Check out the Advanced tab if you want to know what goes on behind the scenes. You can see how the numbers interact in this diagram.
These figures must adhere to two guidelines:

  1. Both assets must have the same worth when the price changes (price *
    quantity)
  2. The quantity of both assets must multiply after the price changes to equal the number before the price changes.

To see how both of these work together to form this ephemeral loss curve, watch the video:

Examples of Impermanent Loss

Let’s look at the details of an example circumstance that an investor like you might face to better appreciate the temporary loss.

We have a USDC/ETH liquidity pool. For example, with an equal percentage of each coin and 1 ETH worth US$100. You provide 1 ETH and 100 USDC to the liquidity pool as a liquidity provider. Because both the ETH and USDC tokens deposited are worth $100 each, the deposit amount is US$200.

Assume the liquidity pool contains 10 ETH and 1,000 USDC. This indicates that you have a 10% stake in the pool.

Because the values of each token in the pool are determined by the ratios of their liquidity pools, they are distinct from exchange prices.

Let’s imagine the price of ETH doubles in the next six months, valuing each ETH at $200 in January 2022. There should be approximately 7.071 ETH and 1,414.21 USDC to maintain the 50/50 ratio.

If you withdraw now, you will receive 0.7071 ETH and 141.42 USDC. It is approximately US$282. However, if you only keep your ETH, you’ll end up with US$300 in tokens (US$100 in USDC and US$200 in ETH).

The disparity of US$18 is the amount of impermanent loss suffered by the liquidity provider. The providers will suffer a larger temporary loss if the pooling ratio changes significantly.

Impermanent loss is only computed for one asset in the aforementioned calculation. Furthermore, it is assumed that one of the assets is steady, albeit this is not always the case.

When Providing Liquidity In Defi, How Do You Prevent Impermanent Loss?

Impermanent loss occurs when the price of your token fluctuates. Like when it fluctuates from the time it was deposited into the pool. The risk rises in proportion to the size of the change. Although providing liquidity to a liquidity pool might be beneficial. When you understand how to avoid temporary loss is critical.

Because liquidity has such a big impact on asset prices. it’s crucial in both traditional markets and decentralized finance (Defi). Anyone who has dabbled with Defi via staking is well aware of the immediate dangers of a liquidity pool.

Impermanent loss, which occurs as a result of providing liquidity in Defi, is one of them. Although temporary loss can be mitigated later. Investors must be aware of it and how to avoid it.

Let’s examine the risks of providing liquidity to a liquidity pool in this tutorial. Including how to avoid them.

Deduction

The promise of AMMs as a method for liberalizing liquidity supply and allowing passive market-making by any customer with untapped capital is jeopardized by impermanent loss.

AMMs are a considerably more robust and economical alternative for driving decentralized liquidity. Because of the advantages of risk-minimized liquidity provision and single-token exposure.

See the Learning List for more information.

  1. Blockchain Technology
  2. Defi
  3. NFTs
  4. DAOs
  5. Crypto
  6. Web 3.0
  7. Altcoin Tokenomics
  8. Metaverse
  9. Smart Contracts

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