📉Understanding Impermanent Loss

What is Impermanent Loss

When you add liquidity to a liquidity pool and the value of the assets you deposited changes from when you placed them, you may experience an impermanent loss. The magnitude of this alteration increases your susceptibility to transient loss. In this instance, the loss is the difference between the dollar value at the time of deposit and the time of withdrawal. Asset pools that stay within a narrow price range will be less at risk of transient losses. For example, various wrapped coins or stablecoins will maintain a pretty small price range. For liquidity providers (LPs), the risk of temporary loss is lower in this scenario.

Given their risk for loss, why do liquidity providers continue to offer liquidity? Well, impermanent loss can still be counteracted by trading fees. Even pools that are quite exposed to impermanent loss can be profitable thanks to the trading fees.

If there’s a lot of trading volume happening in a given pool, it can be profitable to provide liquidity even if the pool is heavily exposed to impermanent loss. This, however, depends on the protocol, the specific pool, the deposited assets, and even wider market conditions.

How to Calculate Impermanent Loss

To calculate IL, the value of the deposited assets in the liquidity pool is comparable to the value of the same assets held in a wallet. To understand this better, consider the example below: Suppose Alex wants to offer liquidity to a 50/50 ETH/SEI pool. In this scenario, let’s say Alex deposits 5 ETH and 5,000 SEI (where the price of 1 ETH = 1,000 SEI). If the pool has a total asset value of 100,000 SEI (composed of 50 ETH + 50,000 SEI), the deposit entitles Alex to 10% of the pool share, which Alex can withdraw at any point. But what if the price of one of the assets changes? After the liquidity provider has made the initial deposit, the price of 1 ETH doubles and starts trading at 2,000 SEI. Arbitrage traders will add SEI to the pool and remove ETH to make the ETH/SEI price match external exchanges. Liquidity pools rely on algorithms to adjust the pool and manage the assets. The constant product formula is the most basic and widely used formula to calculate IL in scenarios like this. Using this formula, we determine: X * Y = K, where X is the amount of token1 and Y is the amount of token2 Based on the formula, initially, we get: 50 (ETH) * 50,000 (SEI) = 2,500,000 After the arbitrage trading, we now calculate the new holdings of the pool: ETH liquidity = square root (constant product K / new ETH price in SEI) Square root (2,500,000 / 2,000 SEI) = 35.355 ETH SEI liquidity = square root (constant product K * new ETH price in SEI) Square root (2,500,000 * 2,000 SEI) = 70,710.678 SEI If Alex withdraws all the tokens at this point, with 10% share in the liquidity pool, a total equivalent to 14,142 SEI (3.5355 ETH * 2,000 SEI + 7,071 SEI) is received. However, if Alex held the tokens instead, they would be worth 15,000 SEI (5 ETH * 2,000 SEI + 5,000 SEI). In this case, Alex’s IL is 15,000 – 14,142 = 858 SEI.

Impermanent Loss Calculators

IL calculators are available to help estimate the potential loss a user may incur when providing liquidity to a specific pool. They take into account various factors, such as the initial asset prices, the pool composition, and the price changes over time. Below are two useful IL calculators: CoinGecko’s Impermanent Loss Calculator GitHub’s Impermanent Loss Calculator

Factors Affecting Impermanent Loss

To effectively navigate IL in the cryptocurrency market, there are several key factors a trader might consider:

• One important factor is the liquidity pool's composition. Generally speaking, pools containing stablecoin pairs or assets with strong correlations have lower IL levels. Comprehending the characteristics of the assets in the pool might aid in evaluating the possible hazards associated with it.

• A key factor to keep in mind is the time horizon. Theoretically, IL is only temporary, so if the asset values eventually return to their starting points, the loss may be lessened or perhaps completely removed. Effectively managing information leakage (IL) therefore requires taking into account the length of time assets are held in pools as well as the possibility that the assets will revert to their original values.

• It is essential to stay updated with the latest developments in the cryptocurrency market. The possible risks and benefits connected with IL may be greatly impacted by the addition of new assets or changes to the market. Reduce the impact of IL by closely monitoring market movements and modifying strategies as necessary.

All examples listed are for informational purposes only. You should not construe this information as legal, tax, investment, financial, cybersecurity, or other advice.