Alluo Academy | What is Impermanent Loss and does it matter?
This article started out as a section in our Yield Farming Academy article. But it grew arms and legs so it’s been given its own place in the Academy.
You can read more of the Academy series here. Or read on to find out more about Impermanent Loss (IL).
So what is this Impermanent Loss then?
Impermanent loss is a temporary loss of funds that can occur when providing liquidity. It’s essentially the difference between the value you would have had if you’d simply held an asset instead of adding that asset to a liquidity pool.
It’s most common in pools where the liquidity provider (LP) has to add two assets in a defined ratio, and one of the assets is volatile in relation to the other e.g. a Uniswap USDT/ETH 50:50 pool.
So for example, if Sarah provided $1000 into the 50:50 Uniswap USDT/ETH pool and ETH was $500 she would have provided 0.5 Eth and $1000 of USDT.
The pool will continue to operate at a steady state until someone uses it to swap ETH for USDT (or vice versa). So, if ETH goes up in value from $1000 to $1500 (and USDT stays at $1), the value of ETH in the pool will be at a discount to fair market value until someone comes to it to swap USDT and buy ETH.
Arbitragers (and arbitrager bots) are therefore incentivised to do this, as they can buy low on Uniswap (in this example) and sell on another exchange for a profit where the price has already risen. 🤑
Doing so will raise the price of ETH in the Uniswap pool and the arbitragers will stop swapping once the price of ETH matches the fair market price. BUT in the process, the number of ETH the liquidity provider can withdraw from the pool has reduced impacting their P&L.🧐
So let’s walk through the example further:
- If Sarah simply held $500 USDT and 0.5 Eth she would have $1,250. That’s $500 USDT + $750 ETH (as ETH has gone up 50%) 🚀
- But as she added liquidity to the pool, she actually has $1224.74. That’s $612.37 USDT and 0.4082 ETH ($612.37) 😢
If she were to withdraw her liquidity from the pool at this point she will have lost $25.26 vs. just holding the ETH and USDT.😳
It’s called impermanent loss because Sarah only realises the loss when she withdraws and could in fact return to $0 or even become an impermanent gain if she continued to leave it in the farm.🤯
As you can see, this can be complex as an increase in token price doesn’t necessarily equal a good thing for LP providers (as in the case above where they would have gained more without providing liquidity).
But also this only represents one side of the coin!
We haven’t included rewards in the equation above. In many situations, the rewards received for providing liquidity can often offset the impermanent loss.
So had Sarah earned more than $25.26 rewards in the same period she would have offset her impermanent loss and may in fact be very happy to continue to provide liquidity.
Conclusion
Impermanent Loss is a phenomenon that can occur when providing liquidity in a pool with two assets in a defined ratio.
It occurs when the value of one of the assets in the pool changes relative to the other asset to a point where the liquidity provider would have been better off simply holding the assets instead of providing liquidity.
However, it is important to note that the potential for impermanent loss should be weighed against the rewards earned for providing liquidity, as these can offset any losses that may be incurred. Not to mention, the asset price change that caused the loss can change, and any losses are only realised when pulling liquidity from the pool.
Ultimately, whether or not it is a good idea to provide liquidity in a pool will depend on the specific circumstances and the potential for both impermanent loss and reward.
But if you’re concerned about the potential to incur IL, it may be more better to look at farms such as Alluo’s Fixed Rate farms where returns are guaranteed for 2 weeks and customers are shielded from any IL. 🚀
How do I find out more and get more involved?
Check out our Blog for more Alluo Academy articles and jump into Discord to talk to the team and community for more insight.
Those that have more to say and want to contribute to the Academy can also hit us up there and make some suggestions!
