The impermanent loss is a concept that can become important for investors in defi (decentralized finance). It is a phenomenon that occurs when you provide assets to a liquidity pool and the value of these assets fluctuates unfavorablely compared to their initial price. Understanding the impermanent loss is essential for all those who want to maximize their yields while minimizing risks in the world of defi. But how does it work exactly? Let's discover it together.
Table of contents
The basics of liquidity pools in deff
The liquidity pools are active reservations deposited by investors, which make available pairs of cryptocurrencies to allow exchanges on decentralized platforms ( DEX ).
Unlike the centralized orders of traditional platforms (such as those used by CEX ), which work by bringing together user purchase and sale offers to find correspondence, Dex use liquidity pools to facilitate exchanges without the need for this orders to match orders.
The centralized order books relate buyers and sellers, by displaying supply and demand prices, but this can lead to delays if no corresponding order is found on low liquidity assets.
In Dex, users can exchange their tokens directly with the pool, without waiting for a consideration, because liquidity is always available. In exchange for their contribution to these pools, liquidity suppliers receive part of the transaction costs generated by the exchanges made in the pool. However, participating in a liquidity pool presents a risk called impermanent loss (impermanent losses).
The impermanent loss in action: how does it work?
The impermanent loss occurs when the prices of the two assets in a liquidity pool change unevenly. The key to this phenomenon lies in the automatic rebalancing of assets in the pool, based on the formula of the automated market maker .
When the price of one of the assets increases or decreases compared to the other, the pool adjusts the quantities of the two assets to maintain a constant ratio (often 50/50) according to their new value. This means that you finish with more than the asset that has risen in value and less than the one that increased the most, compared to what you would have had if you had kept your assets in a portfolio .
For example, if the price of token has increased considerably compared to token B, the pool will rebalance by selling part of the token to buy more token B in order to maintain this balance. The impermanent loss then occurs, because the value of the assets that you can recover may be lower than the one you would have if you had simply kept them in a wallet.
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Although this loss is often temporary, it can have a significant impact on yields if the assets continue to fluctuate unevenly.
Automatic calculation of the impermanent loss
The impermanent loss can be calculated automatically thanks to several online tools such as artisandefi .
Why do we call it impermanent?
The impermanent loss is so called because it is not necessarily permanent. If the prices of assets return to their initial value, the loss fades. However, if you remove your assets while price fluctuation is unfavorable, the loss becomes definitive.
Detailed example of an impermanent loss calculation
Take the example of a liquidity deposit on Raydium of a soil/ray pair with a yield of 45 % per year or 3.75 % per month. It is assumed that the soil increases in a month by 30 % and the RAY by 60 %.
Sol/Ray Pool :
- Initial amount : € 1,000 in soil and € 1,000 in RAY (total of € 2,000).
- Initial soil price : 100 €.
- Initial Ray price : 2 €.
- Annual pool yield : 45 % (about 3.75 % per month)
- We have deposited 10 soil And 500 Ray In the pool, which gives a constant product:
10 soil × 500 Ray = 5000.Here, the constant k = 5000 must remain unchanged.
After 1 month:
- The price of the soil increases by 30 % , so 1 soil goes to € 130.
- The price of the Ray increases by 60 % , so 1 Ray goes to € 3.20.
The AMM must now adjust the quantities of soil and ray to keep the product x * y = k = 5000 constant, while taking into account new prices.
Calculation of new quantities after rebalancing:
New price report :
- The price of the soil is now € 130.
- The price of the Ray is now € 3.20.
- The price ratio is: 130/3.20 longer40.625.
This means that the relationship between the new quantities of soil and Ray in the pool must reflect this ratio.
Rebalancing the quantities :
To maintain balance x * y = 5000 , while respecting the price ratio, the new quantities of soil and ray in the pool will be adjusted.
The new quantities of soil ( x ' ) and Ray ( y' ) must respect:
- x ′ ∗ y ′ = 5000
- The ratio between soil and Ray must be 40.625 or y ′ /x′=40.625 so we have 2 equations and 2 unknown: we can solve the system.
- x ′ ∗ y ′ = 5000
Quantities adjusted after rebalancing:
New quantity of soil (x ') :
Let us calculate the new quantity of soil:
After rebalancing, we therefore have about 11.09 soil in the pool.
New quantity of Ray (y ') :
Now, using the price ratio between soil and Ray to maintain balance, the new quantity of ray will be: y ′ = k/x ′ = 5000/11.09ident 451.15 Ray.After rebalancing, we have around 451.15 Ray in the pool.
Asset value after rebalancing:
Soil value :
- The new amount of soil in the pool is 11.09 soil , with a price of € 130 per soil.
- The value of the soil after rebalancing will therefore be:
11,09×130=1441,70€
Ray value :
- The new quantity of Ray in the pool is 451.15 Ray , with a price of € 3.20 per Ray.
- The value of the Ray after rebalancing will therefore be:
451,15×3,20=1443,68 €
Total value after rebalancing:
- Total value in the pool after rebalancing:
€ 1441.70 (ground) +1443.68 € (Ray) = 2885.38 €
Hodling strategy (keep assets):
If we had simply kept our cryptos in a portfolio, their value would be:
- Floor value : 10 soil * 130 € = 1300 € .
- Ray value : 500 RAY * € 3.20 = € 1600 .
Total by Hodlant: 2900 €.
Calculation of the impermanent loss:
The impermanent loss is the difference between the value we would have obtained by keeping the assets in our portfolio and the value we would get by depositing them in the liquidity pool.
- Value without impermanent loss (Hodl) : 2900 €.
- Value in the pool after rebalancing : 2885,38 €.
The difference is: 2900−2885,38=14,62€.
As a percentage, this represents approximately 0.5 % impermanent loss.
Liquidity pool yield:
Let us not forget the yield of the pool , which is 3.75 % per month.
- Monthly yield = 3.75 % of € 2885.38 = € 108.20 .
Total value after rebalancing and yield:
After adding the yield, the total value of our investment in the pool will be: 2885.38+108.20 = € 2993.58.
Conclusion :
- Liquidity pool : After rebalancing and adding the yield, we have € 2993.58 .
- Hodling : simply keeping his cryptos, we have € 2900 .
In this case, the liquidity pool is more advantageous than the Hodling strategy, because the yield of the pool compensates for the impermanent loss which is low (approximately 0.5 %).
How to compensate for the impermanent loss?
The costs generated by the liquidity pool can help compensate for the impermanent loss. In the previous example, the monthly yield of 3.75 % generates € 101.68 , which compensates for impermanent losses.
Alternatives to liquidity pools to avoid the impermanent loss
For those who want to completely avoid the impermanent loss, there are alternatives such as staking or yield farming . These strategies make it possible to generate yields without exposing your assets to the fluctuation of prices in a pool.
The best DEFI platforms for liquidity supply (Liquidity Providing)
Uniswap , SUDHISWAP , Raydium , Aerodrome Finance or Drift via its Backstop AMM Liquididty (BAL) are AMMs offering potentially attractive yields for liquidity deposit.
The impact of transaction costs on the impermanent loss
The transaction costs generated by pools can play an important role in compensating the impermanent loss. The higher the volume of exchanges, the more the costs you receive as a liquidity supplier can be significant. These generated transaction costs are reflected on the yields offered by the platform for a liquidity pair.
Conclusion: the impermanent Loss, an inevitable but manageable risk?
The impermanent loss is an essential risk in the DEFI, but it is possible to estimate it in order to determine whether the yield allowed by the automated Market Maker sufficiently compensate for these losses.
FAQ on the impermanent loss
1. What is the impermanent loss in deffi?
The impermanent loss is the loss of value that your assets undergo in a liquidity pool due to the rebalancing of the assets operated by the AMM during the fluctuation of the prices of the assets.
2. Is the impermanent Loss permanent?
It becomes permanent if you remove your assets before prices come back to their initial value.
3. How to calculate the impermanent loss?
To calculate the impermanent loss you can follow the example given this example and replace them with your values. However, it is more effective to use online tools that make it possible to calculate the impermanent loss automatically such as artisandefi.
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Noah
Training engineer, I quickly became interested in the field of finance. Convinced that decentralized finance has a bright future ahead of it, I participate in its democratization by developing Crypternon.
