If you’ve been researching yield farming and liquidity pools, you might have come across the term impermanent loss in yield farming. What is an impermanent loss in yield farming, and how does it affect your crypto investment?
Liquidity pool impermanent loss happens when the price of a token increases or decreases after you deposit them in a liquidity pool.
This change is considered a loss when the dollar value of your token at the time of your withdrawal becomes less than its amount at the time of deposit.
Using an impermanent loss calculator, you can calculate the exact percentage lost for any price change.
What is Impermanent Loss in Defi Yield Farming?
Impermanent loss is closely associated with yield farming, a type of investment in which you lend your tokens to earn rewards.
It might sound a bit like staking, but it is a bit more complex. Yield farming involves providing liquidity, or lending your tokens, to a liquidity pool.
The rewards differ depending on protocols. Although yield farming is considered a more lucrative alternative than holding, providing liquidity entails some risks.
The tokens in the liquidity pool and the number of liquidity providers determine the amount of risk for impermanent loss. The token is paired off with another token, with the pairing often consisting of one Ethereum-based token and a stablecoin.
For example, an ETH/DAI liquidity pool has less risk of impermanent loss than an ETH/SUSHI pairing because the former has a stable asset to swap with – DAI.
The price change is called an impermanent loss because prices can always go back to the initial exchange price in the future. The impermanent loss is cancelled if your asset is priced the same as the initial deposit price.
The loss only becomes permanent if you withdraw your funds from the liquidity pool.
But why is the market price in an exchange like Coinbase different from the price in a liquidity pool?
Liquidity pools are different from exchanges because they follow an automated market maker protocol. This specific market-making protocol uses algorithms to determine the price of assets.
Basic liquidity pools like Uniswap follow a constant product money maker algorithm. Unlike other investment options like a time deposit, liquidity pools provide a way for you to trade your assets out at any time, even without buyer and seller orders matching.
Additionally, prices of assets in liquidity pools are influenced by the ratio between them and not by the prices on external markets.
Therefore, any change in this ratio must be carefully assessed to ensure the value of both assets in the pool remain the same. Otherwise, the change might cause a significant change from their price on a regular order book-based exchange.
If this is too complicated for you, no worry, we will provide you the impermanent loss calculator in the next section to simply calculate the impermanent loss in under a minute.
Is it possible to cancel out this loss? It is difficult to completely do away with an impermanent loss unless you get sufficient rewards from trading fees and other protocol-specific incentives.
However, there are several ways to mitigate the losses.
By the end of this guide, we will walk you through a few examples of liquidity pool impermanent loss, how you can calculate it, and how you can avoid it altogether.
Impermanent Loss Calculator
If you have an idea of a future price movement of your asset in the liquidity pool, it will help you to know how much impermanent loss to expect. You can estimate the amount of impermanent loss in advance through an Impermanent Loss Calculator.
The calculator works by setting your two assets’ initial and future prices. This calculator uses the constant product formula, which maintains a 50/50 ratio between the two assets. Use the two-step process:
Step 1: Fill in the initial prices, representing the prices of both assets during the time of deposit.
Step 2: Fill up the future prices. These may be the current or predicted prices of both assets at the time of the planned withdrawal.
In the example below, we calculate an asset with the ratio between asset prices in liquidity pools which is a stablecoin, so it remains at US$1. The calculator indicates that the impermanent loss at that price movement is 1.03%.
The calculator also shows how this price change might use actual values. For example, the calculator shows the price if you simply held US$500 worth of each asset and the price to withdraw both assets from the liquidity pool.
If you plan on investing your tokens into a liquidity pool, it’s a great idea to use an Impermanent Loss Calculator to determine how much risk you’re exposing yourself to.
In the next section, we will explore how this calculator works and how the formula was derived.
How to Calculate Impermanent Loss
Once you have the value of impermanent loss for the given change k, you can multiply that percentage by the initial value to get the actual dollar amount.
For example, if my impermanent loss is 0.6% and the initial price of my asset is US$1000, then the actual liquidity pool impermanent loss is US$1000 * 0.6% = US$6.
Impermanent Loss Examples
To further understand impermanent loss, let’s look at the details of a typical scenario an investor like you might encounter.
For example, we have a USDC/ETH liquidity pool with an equal ratio of each token, with 1 ETH worth US$100. As a liquidity provider, you add 1 ETH and 100 USDC to the liquidity pool. The dollar amount during the deposit is US$200 because both the ETH and USDC tokens deposited are worth 100 each.
Suppose there are 10 ETH and 1,000 USDC in the liquidity pool. This means that you have a 10% share of the pool.
Since the price of each token in the pool relies on the ratios of their liquidity pools, their prices are separate from prices seen in exchanges.
Let’s say that the ETH price doubles in the next six months, meaning each ETH is now worth US$200 as of January 2022. To keep the 50/50 ratio, there should be about 7.071 ETH and 1,414.21 USDC.
If you choose to withdraw now, you are entitled to receive 0.7071 ETH and 141.42 USDC, which is about US$282. However, if you simply hold onto your ETH, you would have US$300 worth of tokens (US$100 of USDC and US$200 of ETH).
The difference of US$18 is known as the amount of impermanent loss the liquidity provider has taken. Bigger changes in the pool ratio will amount to a larger impermanent loss for the providers.
The above calculation assumes that impermanent loss is only calculated for one asset. Further, it also assumes that one of the assets is stable, although that may not necessarily be the case.
Impermanent loss estimation
Impermanent loss can happen no matter what direction the asset price changes.
Let’s look at how much impermanent loss you will receive for various price changes in an ETH/USDC pair.
If the ETH price increases, then:
- A 10% increase will lead to a 0.11% loss
- A 25% increase will lead to a 0.62% loss
- A 50% increase will lead to a 2.02% loss
- A 2x increase will lead to a 5.72% loss
- A 3x increase will lead to a 13.4% loss
- A 4x increase will lead to a 20.0% loss
- A 5x increase will lead to a 25.46% loss
If the ETH price decreases, then:
- A 10% decrease will lead to 0.14% more loss
- A 20% decrease will lead to 0.62% more loss
- A 50% decrease will lead to 5.72% more loss
- A 90% decrease will lead to 42.5% more loss
As you can see, an impermanent loss is inevitable when using automated market makers like a liquidity pool. It decreases your gains and can dramatically increase your losses. The next section will discuss options to avoid or mitigate impermanent loss when yield farming.
How to avoid Impermanent loss
Now that you have a good grasp of what impermanent loss is all about, let’s explore ways to decrease your exposure to impermanent loss.
First, look for stablecoin pairs. If you provide liquidity to a pair like USDT/USDC, then you will not be exposed to any risk of impermanent loss since the prices, as the name implies, are stable. This is an effective strategy in a bear market since you’ll still profit from your share in trading fees.
Another way to minimize exposure to Impermanent loss is to split your crypto assets into two equal portions. Add only one portion into a liquidity pool. Since the other half will simply be held, you’ll be effectively cutting the impermanent loss by 50%.
A downside to this is that fees or benefits are also halved since only 50% of your assets are invested in the pool.
For example, let’s use the case of an ETH/DAI pair. If the price of ETH increases by 50%, then you would experience a 2.02% impermanent loss.
If you invested a total of US$1000, you would lose about US$20 as an impermanent loss. However, if you only invest half of your ETH and DAI pairing into the liquidity pool, your impermanent loss will drop to only US$10.1.
Avoid impermanent loss by avoiding more volatile cryptocurrency pairs. If your research indicates that one of the assets in a pair will outperform the other, you might want to look for more stable pairs.
Look for cryptocurrency pairs that seem like their prices will rise and fall simultaneously. You need to do your research and analysis for this option.
You may also consider looking for LPs with uneven asset ratios beyond the traditional 50/50 split. Services such as Balancer have flexible pools with asset ratios such as 95/5, 80/20, and 60/40. Find out what works for you.
These uneven LPs can help mitigate impermanent loss because a major price movement for a particular asset will have less impact; it covers less than half of the asset’s value.
Lastly, even if you are at risk of impermanent loss, some liquidity pools offer incentives to cancel any potential losses from a price change. If the trading fees are high, then your share of the fees may far outweigh any impermanent loss on paper.
Liquidity mining is also a popular incentive. It gives the liquidity provider a native token as a reward for providing liquidity. It is important to factor in these rewards when assessing whether a potential impermanent loss is risky.
Bottomline
Liquidity pool impermanent loss is an important concept in decentralized finance, particularly yield farming. Understanding the impermanent loss meaning will show how much gains you miss out on by choosing to become a liquidity provider rather than simply holding your assets.
Yield farming is a relatively new space in decentralized finance, so it’s important to understand its risks. Other popular DeFi protocols include DeFi prediction markets and decentralized exchanges that also come with risks and strategies.
Despite the risk of impermanent loss, it is still possible to determine whether a certain liquidity pool is profitable for you. If the returns of your yield have a value higher than your impermanent loss, you will have greater returns than simply holding your assets. You should also consider the fees you can collect as a liquidity provider.
A high trading volume liquidity pool is a good opportunity to cut the fees charged for every transaction. Several factors need to be considered when evaluating your LPs profit potential.
Discover what tools are at your disposal to make better investment decisions, e.g. the Impermanent Loss Calculator. Research everything you need to know about yield farming, selection of token pairings, and risk mitigation techniques. Arm yourself with knowledge before you invest.
