Risk of Impermanent Loss in Liquidity Pools

What is the risk of Impermanent Loss?

Impermanent Loss is the risk that liquidity providers commonly face when they deposit two cryptocurrency assets in a liquidity pool-based automated market maker, such as Uniswap, a decentralized exchange. It typically occurs when the price of the tokens changes compared to when they were deposited, and the ratio of the tokens in the liquidity pool becomes uneven.

Impermanent Loss Example

A liquidity provider in an Automated Market Maker (AMM) usually deposits a 50/50 ratio of both assets in a pool for a specific trading pair. At the moment of deposit, the value of each token deposited must be the same. For example, let’s say 1 ETH is worth 100 USD, and the liquidity provider decides to participate in the ETH-USDT pool. The user deposits 1 ETH and 100 USDT (because 1ETH = 100 USDT) in the pool and gets Liquidity Provider Tokens (LP-Tokens) as a form of receipt for the liquidity provided. If the entire pool contains 10 ETH and 1000 USDT after the deposit, the total share of the pool is 10%.

Closing thoughts

In short, liquidity providers commonly face the risk of impermanent loss when depositing funds in AMMs. You can calculate the impermanent loss by comparing the dollar value if you had held simply held your tokens compared to the value you get if you take your funds out of the liquidity pool at that moment.

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