What is impermanent loss?

As we explained in the previous article cryptocurrency training, there are ways to generate passive income in the cryptocurrency ecosystem. Yes, even in difficult times like these. As we have well learned, liquidity is more than necessary to allow DEXs to flow normally. Providing liquidity is a good way to generate passive income, but it has some risks to take into account, such as permanent loss...

What is impermanent loss?

Impermanent loss is a loss to which our cryptocurrencies are exposed when they are in a liquidity pool. This loss usually occurs when the proportion of tokens in the liquidity pool becomes unbalanced. However, the impermanent loss does not apply until the tokens are withdrawn from the liquidity pool. This loss is typically calculated by comparing the value of your tokens in the liquidity pool versus the value of simply holding them. Since stablecoins have a stable price, liquidity pools using stablecoins may be less exposed to impermanent loss.

How does impermanent loss work?

Let's give an example so that this cryptocurrency training is easier to understand. We add 1 WETH and 1375 USDC to a liquidity pool, with the same value for both tokens. The total value of the tokens rises to $2.750. The pool we have chosen has 10 WETH and 13.750 USDC in the liquidity pool in a 50/50 ratio. This benefits liquidity providers with 10% of pool fees. They will receive these commissions in LP tokens, which they can use to redeem their 10% commissions from the pool whenever we want.

Since the price of tokens depends on the ratios of their liquidity pools, their prices may deviate from the prices of other pools. If the price of WETH rose by 100%, with a value of $2.750 per WETH, the liquidity pool would have changed to 7,071 WETH and 19.445 USDC. This is because the pool ratio has changed, it would no longer be 50/50, which ends up affecting the price of WETH. Since liquidity providers earn a 10% commission from the liquidity pool, we can withdraw 0,7071 WETH and 1944,52 USDC, which is equivalent to $3.889. However, if we hold 1 ETH and 1.375 USDC, they would be worth $5.500. The difference between the two, $1.611, is the permanent loss we are going to experience. A larger imbalance in the pool ratio can turn into a larger impermanent loss.

Does it always have the same impact?

The in-permanent loss may vary depending on the tokens that make up the liquidity pool as well as the number of liquidity providers within the pool. In the example we set out above, the WETH/USDC pool, WETH has a stablecoin to be exchanged. If instead, we add liquidity to a WETH/MATIC pair, the permanent loss can be much greater, given that the two tokens are volatile assets. At the same time, there are also stablecoin pools, such as USDC and DAI. With these pairs we reduce our exposure to permanent loss because they have almost no volatility. In the following graph we can see how the price can affect the permanent loss that we will experience. If the token in which we have invested rises by 500%, we can incur a permanent loss of almost 25%.

How is the impermanent loss calculated?

Since decentralized exchanges (DEXs) use calculations to adjust token values ​​when the ratio changes, we can use a permanent loss calculator to easily calculate potential losses. The page Daily Defi has a tool to automatically calculate the permanent loss that we may suffer based on possible future prices.

In this example, token A (USDC) is $1.375 and token B (ETH) is $1, with a total initial value of $2.750 between the two tokens. Next we go to the “future prices” section. We set the value of the USDC to $2.750 and the WETH to 1.

Given that the value of tokens A and B held would be $1.500, compared to those in a liquidity pool, $1.414,21. This would mean a permanent loss of $85,79.

How can we cover ourselves from impermanent loss?

After seeing how impermanent loss acts on cryptocurrency pairs, let's continue the cryptocurrency education with possible solutions to this dilemma. We already know that liquidity providers usually provide stablecoins and apply their benefits to minimize the impact of permanent loss. There is a way to further decrease the impact, by using liquidity pools that use different ratios to equity. We can use ratios such as 80/20 and even 90/10. If we follow the previous example, normally we would contribute 50% of WETH with another 50% of another token.

With 80/20 pools we only have 20% exposure to the other token. As we see in the following graph, we can see how the impermanent loss would develop in the different ratios. As we see, the 90/10 is the one that suffers the least permanent loss. These ratios can also help us reduce the impact of impermanent loss by providing a smaller difference between holding the token compared to providing liquidity. In the following graph we can see that being in a liquidity pool with 80% WETH and 20% another token would generate more benefits than the 50/50 ratio.

It should be noted that 50/50 pools are much more common than others, especially on Uniswap. Since fees go to liquidity pools, their profitability is determined by the number of users using the liquidity pool. If the ratio is 95/5 but no one is using the pool to trade, we will generate little or no profit.

Conclusions from this cryptocurrency training

Although by providing liquidity we may experience permanent losses, we also have to take into account the profitability of our tokens. If their returns generate a greater return than the amount they lose from the impermanent loss, then we can generate more profits than simply holding our tokens. Furthermore, by receiving the profitability of our tokens in a liquidity pool, we are also contributing to the maintenance of the ecosystem. To close this cryptocurrency training, remember that the more trading volume a liquidity pool has, the more income liquidity providers will generate. Consequently, the more participation we have in said pool, the more income we generate…