Impermanent Loss (IL) is a core concept in the field of decentralized finance (DeFi), particularly a type of risk that liquidity providers (LPs) may encounter when providing liquidity to liquidity pools (LPs) in decentralized exchanges (DEXs). It arises due to the price fluctuations of two or more tokens within the liquidity pool, resulting in a relative loss. Simply put, impermanent loss refers to the potential loss that liquidity providers may face during market price fluctuations, compared to directly holding these tokens.
Although impermanent loss is temporary and can disappear if prices return to their original levels, this loss may become permanent in cases of significant price changes. Therefore, liquidity providers must understand and accept this risk when providing liquidity to the pool.
The Principle of Impermanent Loss
To understand impermanent loss, it is first necessary to grasp the operating mechanism of decentralized exchanges (DEXs). Most DEXs, such as Uniswap and SushiSwap, use a model called Automated Market Maker (AMM). In this model, liquidity providers deposit two tokens into a liquidity pool in a certain ratio, with the most common being a 50:50 ratio. For example, a liquidity provider might deposit an equal value of ETH and USDC into a pool.
The number of tokens in the pool and their prices are kept in balance by a simple formula—the constant product formula, which is:
X * Y = K
Here, X and Y represent the quantity of the two tokens in the pool, and K is a constant. Under this formula, the pool automatically adjusts the token ratio based on trading demand to maintain a constant product.
However, when the price of one token in the pool changes, the ratio of tokens in the pool also changes, leading to a change in the number of tokens the liquidity provider holds. This change is the source of impermanent loss.
Let’s assume you, as a liquidity provider, provide liquidity worth $1,000 to an ETH/USDC pool, with $500 in ETH and $500 in USDC. When you deposit, the price of ETH is $500 per token, so you deposit 1 ETH and 500 USDC.
Now, assume after some time, the price of ETH rises to $1,000 per token. According to the constant product formula, the ratio of ETH to USDC in the pool changes. At this new price level, the amount of ETH in the pool decreases, and the amount of USDC increases to maintain the total value balance in the pool. If you decide to withdraw your liquidity at this point, you’ll find that you no longer have 1 ETH but less ETH and more USDC.
A calculation shows that when the price of ETH doubles, a liquidity provider would withdraw approximately 0.707 ETH and 707 USDC. Although the total value is still $1,414, if you had simply held onto the 1 ETH instead of depositing it in the pool, you would now have 1 ETH (worth $1,000) and 500 USDC, for a total value of $1,500. Thus, compared to holding the tokens directly, you have lost $86. This is what is referred to as impermanent loss.
Will impermanent loss become permanent?
Although it is called "impermanent loss," this loss is not always impermanent. In some extreme cases, the loss can become permanent. The reason it is referred to as "impermanent" is that price fluctuations are usually temporary. If the prices return to the levels they were at when the liquidity provider initially deposited the tokens, the impermanent loss will disappear, and the liquidity provider will no longer incur any loss.
However, if there is a drastic and irreversible price change (for example, a significant rise or fall in the price of one of the tokens), the liquidity provider may suffer a permanent loss in relative value. Therefore, in practice, the "impermanence" of impermanent loss is conditional.
Factors Affecting Impermanent Loss
Magnitude of Price Fluctuations
The greater the price fluctuations, the larger the impermanent loss. This is especially true when the price of one token significantly changes relative to the other token (e.g., a substantial rise or fall in the price of ETH in the ETH/USDC pair), which makes impermanent loss more pronounced.
Composition Ratio of the Liquidity Pool
The most common liquidity pools use a 50:50 ratio, but there are also pools with different ratios (e.g., 80:20 or stablecoin pools). Different ratios can affect the scale of impermanent loss. Generally, the closer the ratio is to 50:50, the higher the risk of impermanent loss.
Trading Fees
Although liquidity providers may incur impermanent loss, they also earn trading fees from transactions within the liquidity pool. These fees can partially offset the impermanent loss. Therefore, liquidity providers in pools with high trading volumes may be able to compensate for their impermanent loss through fee income.
Summary
Impermanent loss is a significant risk faced by liquidity providers in decentralized finance (DeFi) systems. While it does not immediately manifest as a reduction in funds, fluctuations in market prices can lead to potential losses compared to directly holding tokens. The scale of impermanent loss depends on the magnitude of market price fluctuations and the composition ratio of the liquidity pool.
However, liquidity providers can mitigate this risk by choosing low-volatility token pairs, selecting pools with high trading volumes, and closely monitoring market fluctuations. Although impermanent loss is an unavoidable part of the DeFi ecosystem, liquidity providers can still achieve substantial returns through reasonable strategies and risk management. When assessing risk and return, liquidity providers need to consider impermanent loss, trading fees, and token price trends to make the best decisions.
