What is Impermanent Loss?
Impermanent Loss refers to the reduction in value that liquidity providers experience in an automated market maker (AMM) due to price changes of the tokens they have deposited. This occurs because the AMM rebalances the token pair to maintain a constant ratio, which can result in fewer high-value tokens and more low-value tokens in the liquidity provider’s share of the pool.
This phenomenon is termed “impermanent” because the loss is only realized if the liquidity is withdrawn while the price disparity exists. If the price returns to its original ratio, the loss is effectively mitigated.
How Impermanent Loss Happens
Liquidity providers deposit two tokens in equal value into a pool. The AMM uses algorithms to maintain a constant balance between the tokens, allowing for seamless trading. However, if the price of one token changes relative to the other, the AMM adjusts the token quantities in the pool to preserve the ratio. This adjustment can lead to:
- A decrease in the number of high-value tokens the provider owns.
- An increase in the number of low-value tokens.
If the liquidity provider had simply held the tokens outside the pool, their total value might have been higher.
Example of Impermanent Loss
Imagine providing liquidity to a pool with Token A and Token B, where Token A is initially worth $10 and Token B is worth $1. You deposit $500 worth of both tokens, meaning 50 Token A and 500 Token B.
- If the price of Token A doubles to $20, the AMM rebalances the pool, reducing your Token A holdings and increasing your Token B holdings.
- Upon withdrawal, your share of the pool might now be worth $950 instead of the $1,000 you would have if you had simply held onto the tokens.
Mitigating Impermanent Loss
To reduce the risk of impermanent loss, liquidity providers can:
- Choose token pairs with lower volatility, such as stablecoin-stablecoin pools.
- Diversify by providing liquidity across multiple pools.
- Take advantage of pools that offer additional rewards or incentives, such as transaction fees or governance tokens, to offset the loss.
Understanding impermanent loss is essential for liquidity providers, as it helps them make informed decisions about staking tokens in AMMs and balancing the potential risks with the rewards of earning transaction fees.