All crypto investors in Decentralized Finance (DeFi) should be aware of a common risk called impermanent loss.
It happens when the token prices have changed over time after you deposit the same tokens into an automated market maker (AMM) exchange.
Basically, impermanent loss is the value difference of two crypto prices after you provide liquidity to an AMM compared to a hypothetical scenario where you simply HODL the same two crypto over the same period.
If you are not familiar with AMM, it might sound confusing. But don’t worry. I will explain further below.
Before we learn more about impermanent loss, we must understand the basic structure of an automated market maker (AMM). This is important because impermanent loss itself is a native feature of AMM.
Crypto growth has been significant in the past few years. Many brilliant minds in the industry have successfully developed DeFi applications that allow crypto investors to earn money passively.
One of the most common ways to make money is by providing liquidity to an automated market maker decentralized exchange (also known as AMM DEX). Some people use the term AMM and AMM DEX interchangeably.
Some of the perfect example of AMM DEX is DeSwap. Unlike more traditional order book DEX-es, AMM DEX-es utilize liquidity pools to act as counterparties.
In AMM DEX-es, they usually impose a 0.3% fee on each transaction (fees might vary on different DEX-es). These fees are paid straight to liquidity providers. The great thing about AMM is that anyone with money can become a liquidity provider by depositing two tokens at once and converting them to a liquidity provider (LP) token.
For example, John goes to Uniswap and he sees the opportunity to make money from ETH-USDC trades. He has 2 ETH and $2,000 USDC. Let’s say, at the time John goes to Uniswap, each ETH is priced at $1,000 USDC.
John can provide liquidity to Uniswap by giving his 2 ETHs and $2,000 USDC (they need to be equal in valuation at the time you provide liquidity).
In exchange, Uniswap will give ETH-USDC LP tokens to John. But as you know, ETH’s price won’t stay the same all the time. When the price of ETH changes, the value of John’s ETH-USDC LP token will also change. The difference of these prices exposes John to impermanent loss.
As explained at the beginning of this article, impermanent loss is the comparison between a situation where you provide liquidity to an AMM vs. a hypothetical scenario where you decide to HODL. Let’s just use John again as our example for an easier explanation.
The price of each ETH is $1,000 USDC and John decides to provide liquidity to Uniswap with his 2 ETH and $2,000 USDC. In the same Uniswap’s ETH-USDC pool, there’s a total of 20 ETH and $20,000 USDC thanks to other liquidity providers like John. That means, John contributes to a 10% share of this ETH-USDC pool.
Imagine the situation where a few months later ETH price goes up to $4,000 USDC each. This means every ETH inside that ETH-USDC pool will become more expensive, and thus, the ratio between ETH and USDC will also change.
In this situation, the traders will provide more USDC to the liquidity pool while they take out ETH from the same pool until the ratio mirrors the latest price.
Now let’s say John wants to withdraw his ETH and USDC back to his wallet. But now there is a total of 10 ETH and $40,000 USDC in this pool. When John converts back his LP token consisting of 10% share of this ETH-USDC pool, he would get 1 ETH and $4,000 USDC.
How much profit does John make? Let’s calculate together:
John started with 2 ETH (priced at $1,000 each at the time) + $2,000 USDC => that means the total value of John’s crypto was $4,000.
But now he has 1 ETH (priced at $4,000 each) + $4,000 USDC => now the total value of John’s crypto is $8,000.
Not bad! John has made a profit of $8,000-$4,000 = $4,000.
However, imagine if within the same time period, he was simply HODL-ing both his original 2 ETH and his $2,000 USDC without providing liquidity to Uniswap. In this second scenario, his 2 ETH (priced at $4,000 each) would have been worth $8,000. Combined with his $2,000 USDC, he would have a $10,000 total crypto value.
Once again, In scenario 1 above where he provides liquidity, he would have increased his crypto total value only from $4,000 to $8,000. Meanwhile, in scenario 2 where he was just HODL-ing, his total crypto value would have increased from $4,000 to $10,000. His total profit is $6,000.
This difference between the total crypto value in scenario 2 ($10,000) and total crypto value in scenario 1 ($8,000) is what people call an impermanent loss. In our example, John’s impermanent loss is $2,000.
But just for the sake of our explanation, let’s estimate our impermanent loss without calculating these swap fees.
Also, please take note that impermanent loss happens in both directions (not only when the token price goes up). In order to estimate your impermanent loss in a negative direction, you can just above John’s example, but you hypothetically calculate if the token price drops instead of going up.
If you are wondering why to bother to provide liquidity if there’s a risk of impermanent loss, the answer is actually quite simple. Apart from earning the swap fees, there are also multiple other potential benefits. In many newer AMM DEX-es, they usually provide further rewards by giving out their protocol tokens.
So, when you provide liquidity to these specific AMM DEX-es, you will not only earn swap fees, but you will also earn their tokens as a reward. When you provide liquidity for a longer period of time, you will also get more of their tokens. This mechanism is called DeFi liquidity mining or yield farming.
This is highly dependent on your own personal preference. Many AMM DEX-es give big rewards, while others are more stingy. Whether you think it’s worth it to provide liquidity or not, all depends on your personal financial situation. Just remember that there’s always a risk of impermanent loss in the crypto and DeFi world.