Impermanent Loss

Impermanent loss is when a liquidity provider has a temporary loss of funds because of volatility in a trading pair.

What Is Impermanent Loss?

Impermanent loss can arise when there is a price discrepancy between the two assets a trader holds on a DEX, usually a cryptocurrency and a stablecoin (such as USDC). When the price of the cryptocurrency falls relative to the stablecoin, the trader can experience a loss due to the difference in prices. This is known as impermanent loss.

How Does Impermanent Loss Work?

Impermanent loss occurs when traders use a DEX to buy one asset with another asset. For example, if a trader buys Ethereum using USDC, then the trader is exposed to the price movements of both assets. If the price of ETH falls relative to USDC, the trader’s profit from the trade will decrease or even become a loss. This is because they have to sell the ETH at a lower price to get back to the original USDC amount.
Let’s imagine that a provider needs to offer equal levels of liquidity in both USDC and ETH but suddenly, the price of ETH goes up. This creates an opportunity for arbitrage because the price of ETH in the liquidity pool now doesn’t reflect the market price. Other traders will buy ETH at a discounted rate until the equilibrium is restored.
After arbitrage, a liquidity provider may end up with a greater amount of USDC and slightly less ETH. Impermanent loss is the difference between the trader’s new portfolio balance and what they would have had if they had just held on to their old balance. The loss is realized when a trader withdraws the liquidity from the pool. 

How to Avoid Impermanent Loss?

One way to prevent impermanent loss is to use stablecoins, such as USDC and DAI, or wrapped versions of the same assets like wBTC offered by Curve. Balancer also offers arbitrary weights for its liquidity pools different from the 50/50 model, which can reduce the risk of impermanent loss if a token has a higher weight in the pool. 
Additionally, a few DeFi protocols are beginning to explore innovative solutions like price oracles used by Bancor, and single-sided liquidity pools employed by Tokemak, where the protocol’s native token absorbs the risk of impermanent loss in exchange for swap fees and bribe rewards.

Impermanent loss can also be minimized by setting up a portfolio of assets that are relatively well-correlated. This way, when the prices of the assets diverge, the portfolio will remain relatively balanced, and the trader can avoid any unexpected losses. 

Also Read: Impermanent Loss: What Is It and How Can I Reduce Its Impact?