Risk of Impermanent Loss in Liquidity Pools
In the DeFi world, being a liquidity provider in a protocol such as Uniswap — a major decentralized exchange — can be very lucrative.
If you’ve been involved in the world of crypto for a while, you may have come across the term “Impermanent Loss,” which is the risk that all liquidity providers are exposed to when depositing funds in dual-asset pools in DeFi protocols.
To understand the concept of Impermanent Loss, you need to understand what Liquidity Pools are. Read our article about liquidity pools here.
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.
This loss is not realized until these funds have been withdrawn and is commonly determined by comparing the dollar value of having participated in the liquidity pool to the value of simply having held the tokens in your wallet. A loss is realized if the dollar value of having held the tokens is greater than that of having participated in the liquidity pool.
Given the risk, why would liquidity providers want to provide liquidity in a pool-based automated market maker? Well, these losses can be mitigated by the liquidity providers’ trading fees as participants in the pool. Currently, Uniswap charges a 0.3% fee on every trade, which goes to the liquidity providers of that specific trading pair pool.
Providing liquidity in the Cross-Chain Bridge does not entail the risk of Impermanent Loss because it uses single-asset liquidity pools. By design, liquidity providers in Cross-Chain Bridge are never exposed to the risk of Impermanent Loss.
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%.
Using the example above, if the price of ETH went to 400 USD, 1 ETH would be worth 400 USDT. This would mean the liquidity provider has an Impermanent Loss at that specific time because if the user had simply held the 1 ETH and the 100 USDT in their wallet, it would total 500 USD in value. But, having these funds in the liquidity pool means there is a loss of 20% if the user decides to withdraw the funds at that time. It would result in a withdrawal value of 0.5 ETH and 200 USDT, totalling 400 USD.
Since this is an Automated Market Maker, the aforementioned price change of ETH to 400 USD means the ratio in the liquidity pool has also changed, i.e., there are now 5 ETH and 2000 USDT. The ratio of the assets in the pool determines the price of the assets.
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.
One of the ways to avoid this risk is to provide liquidity in single-asset liquidity pools, such as those offered by the Cross-Chain Bridge.
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