Impermanent Loss

Understanding Impermanent Loss

At its core, impermanent loss is the difference in potential earnings between holding tokens in an AMM and simply holding them in your wallet. Impermanent loss occurs when the price of tokens inside a pool deviates from when they were initially deposited. If the prices return to their initial state, the loss is impermanent since the value returns to its original state. Although, if the prices remain diverged, the loss becomes permanent.Though such losses can be offset by trading fees earned from liquidity provision, a clear understanding of impermanent loss dynamics remains crucial.

When a token price rises or falls after you deposit it in a liquidity pool, this is known as crypto liquidity pools' impermanent loss (IL).

Yield farming, in which you lend your tokens to gain rewards, is directly related to impermanent loss. However, it is not the same as staking, as investors are required to inject money into the blockchain to validate transactions and blocks to earn staking rewards.

On the contrary, yield farming entails lending your tokens to a liquidity pool or providing liquidity. Depending on the protocol, the rewards vary. While yield farming is more profitable than holding, offering liquidity has its risks, including liquidation, control and price risks.

The number of liquidity providers and tokens in the liquidity pool defines the risk level of impermanent loss. The token is coupled with another token, usually a stablecoin such as Tether (USDT) and an Ethereum-based token like Ether (ETH). Pools with assets like stablecoins within a narrow price range will be less vulnerable to temporary losses. As a result, liquidity providers face a lower risk of impermanent loss with stablecoin in this scenario.

So, since liquidity providers on DEX, like KayenSwap, are vulnerable to future losses, why do they continue to provide liquidity? It's because trading fees may compensate for the temporary loss. For instance, pools on Uniswap, which are highly susceptible to temporary loss, can be profitable due to trading fees (0.3%).​

In Short,

Impermanent Loss (IL) occurs when the value of your assets in a liquidity pool changes compared to when you deposited them. It's termed "impermanent" because the loss can be reversed if the asset prices return to their initial state when deposited.

Understanding IL through a Hypothetical Scenario:

Imagine you're a liquidity provider wanting to join a 50/50 ETH/USDT pool. You decide to deposit 10 ETH and 10,000 USDT, given that 1 ETH is equal to 1,000 USDT.

The pool's total value before your deposit is 100,000 USDT (equivalent to 50 ETH + 50,000 USDT). After your deposit, you now own 20% of the pool. Here's how we calculate it:

Your Share (%) = (Your Deposit in USDT / Total Pool Value in USDT) * 100

In this case:

Your Share (%) = (20,000 USDT / 100,000 USDT) * 100 = 20%

Receiving Liquidity Pool Tokens:

Upon depositing your assets, you receive tokens representing your share of the pool. You can redeem these tokens for your share of the pool's assets at any time.

The Risk of IL:

Your risk of IL stems from your share being a percentage of the pool rather than a fixed number of tokens. If the value of the deposited assets changes significantly, you could be exposed to IL. Notably, the greater the price shift, the higher the potential IL.

Calculating Impermanent Loss:

Let's say the price of ETH doubles to 2,000 USDT after your deposit. The pool balances the asset values using the constant product formula:

ETH Liquidity * USDT Liquidity = Constant

For our example:

50 ETH * 50,000 USDT = 2,500,000 (Constant)

If the price of ETH is now 2,000 USDT, the pool adjusts to:

ETH Liquidity * USDT Liquidity = 2,500,000 (Constant)

This results in new pool balances where ETH Liquidity decreases and USDT Liquidity increases.

The Effect on Withdrawal:

If you decide to withdraw at this new price, you would get:

• 7 ETH (20% of 35 ETH)

• 14,142 USDT (20% of 70,710 USDT)

The total value of your withdrawal would be 28,142 USDT. However, if you hadn't deposited into the pool, your assets could have been worth 30,000 USDT (10 ETH at the new price of 2,000 USDT plus the original 10,000 USDT).

How to avoid Impermanent Loss?

• Impermanent loss occurs when there is a significant price difference between the assets in the liquidity pool. Therefore, you should consider the historical price movement and volatility of the assets before providing liquidity.

• Use correlation analysis to determine the relationship between the assets you're providing liquidity for: - If the assets are highly correlated, it may reduce the risk of impermanent loss - If the assets have a low correlation, it may increase the risk of impermanent loss

• Liquidity pool size and trading volume can affect the risk of impermanent loss. Generally, larger liquidity pools and higher trading volumes can reduce the risk of impermanent loss. Y

• Impermanent loss is an ongoing risk, and you should monitor your liquidity pools regularly to adjust your strategy as necessary. This may involve rebalancing your liquidity, adjusting your price ranges, or withdrawing liquidity altogether