So, you’re getting into decentralized finance and want to try your hand at providing liquidity? Not so fast — make sure you understand what impermanent loss is first.
On Providing Liquidity to a Decentralized Finance Protocol
Decentralized finance, commonly abbreviated as DeFi, works differently from centralized financial institutions such as banks. Since DeFi protocols don’t have access to vast money vaults to supply monetary liquidity, they must rely on individual investors to provide liquidity for the DeFi protocols’ treasuries. These liquidity providers, or LPs for short, are what make DeFi decentralized — it’s essentially peer-to-peer finance.
This is what powers the automated money maker (AMM) trading pairs on a decentralized exchange — an LP supplies funds in a trading pair, allowing users to access the funds in this pool and swap money back and forth. One key thing to keep in mind is that the funds the LP supplies to the liquidity pool become locked in the pool until they are withdrawn.
So, What is Impermanent Loss?
‘Impermanent loss’ simply refers to a loss incurred on an investment as compared to the value the investor would have had if they had held on to their funds. The loss is ‘impermanent’ until the investment is cashed out — then it becomes permanent. For example, if anybody who bought crypto during the last bull run decided to cash out in today’s bear market, their impermanent loss will become quite permanent and they would stand to lose a fair deal of money compared to their initial investment. That’s why we HODL.
In the world of DeFi, ‘impermanent loss’ is used more specifically to describe losses LPs incur from price fluctuations of the cryptocurrencies they lock in liquidity pools with trading pairs, as opposed to if they had just kept those tokens in their wallet. This happens because trading pairs on an AMM must always remain balanced in value, even if arbitrage traders have bought up some of one cryptocurrency and added more of the trading pair’s corresponding token to the liquidity pool.
Why Do LPs Provide Liquidity Then?
In order to offset impermanent loss, DeFi protocols typically pay trading fees to the LPs, and also reward LPs with the protocol’s governance tokens. LPs bank the trading fees and either sell or stake the governance tokens to make a profit and recoup any losses they would have made from impermanent loss on the liquidity pool. It’s usually enough for an LP to be profitable despite impermanent loss if they pay attention to what they’re doing, but not always.
Some DeFi protocols also have certain features that help LPs protect against impermanent loss to some degree. For example, ICON has the upcoming Convexus protocol (launching soon!) which lets liquidity providers determine a specific trading price range for their liquidity pools.
It’s important to stress that providing liquidity on a DeFi protocol is always a risky endeavor that should only be undertaken after one fully understands the risks involved and is able to calculate their risk factor.
How Does Impermanent Loss Work, Exactly?
It’s a bit complex, but not overly so:
Theoretically speaking, say the current price of ICX was US$1, and you put 100 ICX and 100 bnUSD into a trading pair on the Balanced decentralized exchange. The total dollar value of your deposit is US$200. Your funds would usually be combined with those of other LPs who provided the same trading pair, and you’d receive a percentage of the total trading fees, etc., but for simplicity’s sake let’s pretend that this trading pair is composed of your funds alone.
Now, say the price of ICX suddenly jumps to US$5, a stellar price increase of 400 percent. People will swoop in to perform arbitrage trades very rapidly to take advantage of this opportunity (your trading pair is still trading at just one buck!), eventually resulting in the pool rebalancing to reflect the new price. (It’s important to remember that automated money makers don’t have order books — liquidity in each pool remains constant, and the token prices are determined by the ratio between the number of tokens in each trading pair.)
So, what happens in our example? Assuming the price of ICX rose by 400% to US$5, arbitrageurs would have bought up half the ICX, leaving the trading pair with 500 ICX and 2000 bnUSD. If you cashed out, your initial US$2,000 investment would now be worth US$3,500 — a pretty profit!
But wait. If you had simply held on to your original 1000 ICX and 1000 bnUSD, your tokens would actually be worth a whopping US$6,000 today, thanks to that 400% ICX price jump. Even though the liquidity pool would have made you a profit, you would have had a much larger profit if you hadn’t invested those tokens at all.
That’s impermanent loss.
For those who prefer a more visual explanation, I would recommend this excellent video that does a deep dive into the subject of impermanent loss:
Another View on Impermanent Loss
Scott Smiley, an early contributor to Balanced, is quick to point out that the term ‘impermanent loss’ is actually a misleading misnomer, and isn’t anything new:
“I don’t love how the broader DeFi community has explained being a liquidity provider. ‘Impermanent Loss’ or ‘IL’ is not anything new and it’s a misleading term imho,” Smiley said in a tweet thread last December. “Deciding to be an LP is just like any other trade. You’re taking a position and hoping it goes up in value more than other similar opportunities. Risk should justify reward. There is always the opportunity cost of other trades you *could have* made.”
He illustrated with an example: “If somebody bought $100 of ETH that is now worth $90 and still holding, that’s an unrealized loss, or just being ‘down’ in a trade. They were better off holding 100 USD. They can choose to sell now for a loss or choose to keep holding. Nobody calls this impermanent loss. Yet for some reason, if somebody deposits $10k worth of assets into an LP, but they would have had $11k worth of assets by simply holding them, that’s called ‘Impermanent Loss’. No.”
“Each trade has an outlook. Are you bullish or bearish on your LP position right now and why? Are there other opportunities of similar risk but better return out there? That’s all that matters, not this made up term IL, not your sunk cost or what you *could* have made,” Smiley said.
