<p>Impermanent loss (IL) is a loss of funds that a  user will incur when they provide liquidity on Automated Market Making  (AMM) exchanges. AMM’s utilize an algorithm and game theory to generate liquidity, in turn, creating IL through the arbitrage opportunities presented.</p><h2 id="header-0">AMMs, DEXS and Impermanent Loss</h2><p>As  Decentralized Finance (DeFi) has experienced a continued boom in the past six months, we have seen a rise in decentralized exchanges (DEX),  the largest of which being UniSwap, SushiSwap, and PancakeSwap. These  DEX’s rely on automated market marking (AMM) technology, which uses an  algorithm and game theory to create a working exchange-- “DEX.” AMM’s utilize liquidity pools to generate liquidity for specific pairs; this technology relies on arbitragers to govern the price, which introduces impermanent loss (IL), something that users will incur when providing liquidity to these protocols.</p><p>Before we jump into IL, last week’s installment of Cryptonomics covered <a href="https://www.bsc.news/post/cryptonomics-decentralized-exchanges-dex" rel="noopener noreferrer nofollow">Decentralized Exchanges</a> in-depth. I highly suggest touching upon the subject to better understand Impermanent Loss, especially for those who do not know how  DEX’s operate.</p><p><img src="https://academy-public.coinmarketcap.com/optimized-uploads/bff65b669557472fad5ad225125e783b.jpeg" /></p><h2 id="header-1">What is Impermanent Loss (IL)</h2><p>Impermanent  loss is a loss of funds that a user will incur when they provide  liquidity. The name impermanent stems from the fact that the loss is  temporary and can be recovered if asset prices return to their original  state, which often does not happen. This loss is calculated based on  your deposited assets’ worth at the time of deposit versus each asset’s  current value.</p><p>Liquidity providers must provide their assets in  1:1 ratio, 50/50 CAKE/BNB, for example. The AMM then uses this liquidity  to facilitate transactions and arbitragers will ensure that the price  reflects the “true” price among all exchanges. AMM technology relies on  this arbitrage to maintain the correct price; on the other side of the  arbitrage are the liquidity providers, selling or buying at a premium.  This is most visible in high volatility pairs with low correlation as  there is continuously an arbitrage opportunity that users will take  advantage of. Impermanent loss is pertinent in traditional liquidity  pools due to the arbitrage opportunity the AMM technology relies on.</p><h2 id="header-2">IL example</h2><p>So let’s use a BNB/CAKE pool, for example. Lets assume that BNB &#61; $40 and CAKE &#61; $0.50</p><p>Currently,  if a user wants to provide liquidity 2BNB($80) worth of CAKE/BNB they  would deposit 1 BNB and 80 CAKE as liquidity pools require a 1:1 ratio  of assets.</p><p>This also means that one BNB is equivalent to 80 CAKE  at the deposit time, resulting in a total deposit of $80. There is not  only one user in this liquidity pool; for example, lets assume 1 BNB and  80 CAKE results in 1% of the total pool share, meaning the pool  contains 100 BNB and 8000 CAKE. So what happens when the price changes?</p><p>Let’s  say the price of CAKE begins rising on the Binance exchange to $1 per  CAKE token; users will take advantage of this arbitrage opportunity  buying CAKE from the AMM and selling it on Binance, causing liquidity  providers IL through taking advantage of the temporary price  discrepancy. The best way to understand this is that the CAKE ratio is  changing in the pool; instead of the collection consisting of 100 BNB  and 8000 CAKE, it now consists of 150 BNB and 4000 CAKE, as the ratio  must remain 1:1. So what happened to our initial users share?</p><p>The  user’s share is now 1.5 BNB and 40 CAKE, which equates to $100, but if  this user held each asset individually, they would instead have $120.  This is the impermanent loss in action, as arbitragers begin to buy CAKE  with BNB, the pool shifts’ ratio, allowing the arbitragers to profit  off the liquidity providers.</p><p>This same scenario will play out when  the price of an asset decreases. As arbitragers take advantage of the  price discrepancy, the liquidity providers will have more of the  “weaker” token to balance the pool ratio.</p><h2 id="header-3">Impermanent Loss Overview</h2><p>Impermanent  loss is bound to occur in all liquidity provision scenarios. The most  common way of realizing the loss is through comparing the value of LPing  vs. Holding each asset individually (HODLing). As previously mentioned,  impermanent loss affects users equally whether the price goes up or  down.</p><p>The following graph has been developed to display the effects of IL:</p><p><img src="https://academy-public.coinmarketcap.com/optimized-uploads/d0f303f0c76e4c819efe5d0f88099218.png" /></p><p>This graph shows IL based on price change without accounting LP incentives. The chart displays the following data:</p><p>a 1.25x price change results in a 0.6% loss relative to HODLa 1.50x price change results in a 2.0% loss relative to HODLa 1.75x price change results in a 3.8% loss relative to HODLa 2x price change results in a 5.7% loss relative to HODLa 3x price change results in a 13.4% loss relative to HODLa 4x price change results in a 20.0% loss relative to HODLa 5x price change results in a 25.5% loss relative to HODL</p><p>Overall,  these figures are essential to keep in mind as they give liquidity  providers an idea of how much they should be compensated while providing  liquidity. If a user knows they will receive more in rewards than lost  in IL, it is most likely a no-brainer to provide liquidity.</p><h2 id="header-4">Why Provide Liquidity?</h2><p><img src="https://academy-public.coinmarketcap.com/optimized-uploads/9b69fb5e6d334682af0704fa044cda37.jpeg" /></p><p>From  a glance, it seems like it makes no sense for users to provide  liquidity to AMM’s, but there is more. Impermanent loss has been  factored in by these DEX’s, so they give liquidity providers incentives  to combat this risk. Typical AMM’s allocate a .3% trading fee to  liquidity providers, which allows LP’s to profit based on the  transaction volume.</p><p>On top of this, most AMM’s offer additional  rewards to liquidity providers by providing users with governance  tokens. LP’s are heavily incentivized to provide liquidity between the  transaction fees and governance rewards, making it worthwhile for  specific pairs.</p><h2 id="header-5">Correlation In a Bull Market</h2><p><img src="https://academy-public.coinmarketcap.com/optimized-uploads/e29c406e315344e6b1ed358e89f77e79.jpeg" /></p><p>Typically  the best assets to pair together are ones that have a high correlation  and are not volatile. While it is hard to find un-volatile assets in the  crypto-space, it is much easier to find correlated assets. This rings  especially true in the bull market phase as crypto markets are highly  auto-correlated.</p><p><em>Auto-correlation refers to the delayed  correlation or copy, meaning cryptocurrencies will typically behave very  similarly over time.</em></p><p>This brings us into an undiscussed  power of liquidity providing. As price fluctuates and one asset  outperforms another, you end up selling the more expensive asset for the  &#34;lagging&#34; one. This acts as a portfolio that rebalances profits into  the underperforming token. This rebalancing can be extremely powerful,  considering how heavily correlated crypto assets are. If and when the  other token “catches up”, it will have allowed the user to maximize the  gains as the user caught both of the assets rallies.</p><p>We have a <a href="https://www.bsc.news/post/dive-into-defi-the-smart-compound-earnings-machine" rel="noopener noreferrer nofollow">Dive Into DeFi article</a> which specifically outlines these aspects of liquidity provision.</p><p>‍</p><h2 id="header-6">Stay SAFU</h2><p>Overall,  IL is a crucial concept that all liquidity providers must understand.  It is inevitable and will be present in all liquidity pools, besides  stablecoin pools with perfect correlation. IL is not a reason to avoid  LPing; it is just a cost that comes with earning the additional rewards.</p><p>The key is weighing the opportunity costs of HODLing assets  individually vs. LPing them to earn extra rewards at the expense of  impermanent loss. If the liquidity rewards outweigh the IL potential,  then why would a user not participate in liquidity provision? With every  investment, that is the most challenging part, recognizing and  understanding the most optimal investment.</p><p><img src="https://academy-public.coinmarketcap.com/optimized-uploads/4a01311bb0f048a1868633ad58c5a4ea.png" /></p><p>I  hope this article helps beginner and experienced users better  understand the underlying risk of providing liquidity and impermanent  loss. It isn’t a reason not to provide liquidity, but merely an  investment aspect, which users will incur in nearly all LP situations.</p>

What is Impermanent Loss

Table of Contents

BSCN

Other articles published on Oct 17, 2022

HELPING ANIMALS WITH IGUVERSE IS EASY

PIP.me 2.0 solution serves as a personalized eWeb3 page for every service user

Solar Q3 Update — Part 4

Snoop Dogg’s music video is a combination of ‘Curb Your Enthusiasm’ With Web3

ApeCoin DAO considers delaying APE staking and introducing a bug bounty scheme

Celebrating one year with NEAR

Join our free newsletter for daily crypto updates!