What Is Impermanent Loss?

Impermanent loss is one of the most crucial risks faced by liquidity providers in the world of decentralized finance (DeFi). This term describes the temporary loss of funds caused by price volatility within a trading pair. Particularly common in automated market maker (AMM) platforms, impermanent loss affects users who contribute assets to liquidity pools.

In this in-depth guide, we’ll explore what impermanent loss is, how it occurs, how it’s calculated, and strategies to mitigate its impact.

What Is Impermanent Loss?

Impermanent loss refers to the potential reduction in value that occurs when a liquidity provider deposits assets into a pool and the price of one or both assets changes compared to when they were deposited. The loss is considered “impermanent” because it only becomes permanent once the liquidity is withdrawn.

Example:

You deposit 1 ETH and 1,000 USDT into a liquidity pool when ETH = 1,000 USDT.
The price of ETH rises to 1,500 USDT.
If you had held the ETH instead of providing liquidity, your gains would be higher.
However, due to how AMMs balance token ratios in the pool, your withdrawal results in more USDT and less ETH.

The opportunity cost of holding vs. pooling is what we call impermanent loss.

How Does Impermanent Loss Happen?

Impermanent loss occurs when there’s a divergence in the price ratio between the two tokens in a liquidity pair. The larger the divergence, the greater the impermanent loss.

Here’s how it unfolds:

As one token in the pair increases or decreases in value, the AMM algorithm adjusts the token ratio in the pool.
This rebalancing ensures arbitrage opportunities but alters your proportional share of each asset.
When prices shift significantly and you withdraw your funds, you receive fewer high-value tokens than you initially deposited.

This phenomenon is built into how AMMs function and can impact profits unless properly managed.

How to Calculate Impermanent Loss

There’s a mathematical formula used to estimate impermanent loss. One simplified version looks like this:

Impermanent Loss (%) = (2 × √P) / (1 + P) – 1

Where P is the price change ratio between the assets.

Example Calculation:

Original price: 1 ETH = 1,000 USDT
New price: 1 ETH = 2,000 USDT → P = 2
Impermanent Loss ≈ 5.72%

So, if you had simply held ETH, your gains would be 100%. In contrast, liquidity provision in this case would yield roughly 94.28% of that, showing a loss in potential profit.

Platforms Where Impermanent Loss Commonly Occurs

Impermanent loss is commonly associated with AMM-based DeFi platforms, including:

Uniswap (V2 & V3)
SushiSwap
Balancer
PancakeSwap
Curve Finance (optimized for stablecoins, resulting in minimal impermanent loss)

Liquidity providers on these platforms earn transaction fees or farming rewards but must weigh them against potential impermanent loss.

How to Mitigate Impermanent Loss

While it’s difficult to completely eliminate impermanent loss, there are several strategies that can reduce its impact:

1. Provide Liquidity to Stablecoin Pairs

Examples: USDC/DAI, USDT/USDC
Stablecoin pairs experience minimal price movement, which greatly reduces impermanent loss.

2. Use Correlated Assets

Choosing pairs with similar price movement (e.g., WBTC-BTC) helps minimize divergence.

3. Utilize Concentrated Liquidity (Uniswap V3)

Platforms like Uniswap V3 allow providers to select price ranges for their liquidity, offering more control and potentially reducing exposure.

4. Opt for Protocols with Impermanent Loss Protection

Some protocols (e.g., Bancor) offer insurance mechanisms that cover or mitigate impermanent loss over time.

5. Limit the Duration of Liquidity Provision

Providing liquidity for shorter periods reduces the chance of being impacted by significant price swings.

Balancing Risk and Return

Liquidity providers must ask a fundamental question:

“Do the rewards from fees and farming outweigh the potential losses from impermanent loss?”

If the answer is yes, then liquidity provision remains profitable. However, this balance depends heavily on factors like:

Trading volume in the pool
Price volatility
Type of tokens
Duration of staking

Frequently Asked Questions

Is impermanent loss always guaranteed?

No. If token prices return to their original ratio before withdrawal, the impermanent loss can disappear entirely.

When does impermanent loss become permanent?

Once you withdraw your assets from the pool, any losses incurred are realized and become permanent.

Is liquidity provision worth it despite impermanent loss?

It depends. In high-volume pools with generous fee rewards or incentive programs, it may still be highly profitable despite the risk.

Knowledge Is the Key to Managing Impermanent Loss

Impermanent loss is a complex yet essential concept in DeFi. While it poses a significant risk to liquidity providers, it can be managed or mitigated through informed strategies and smart pool selection.

If you’re considering participating in liquidity pools, understanding impermanent loss is crucial for risk management and profitability. Armed with the right knowledge, DeFi investors can make informed decisions that balance reward and risk effectively.