If you’ve been involved with DeFi at all, you almost certainly heard this term thrown around. Impermanent loss happens when the price of your tokens changes compared to when you deposited them in the pool. The larger the change is, the bigger the loss.

DeFi protocols like Uniswap, SushiSwap, or PancakeSwap have seen an explosion of volume and liquidity. These liquidity protocols enable essentially anyone with funds to become a market maker and earn trading fees. Democratizing market-making has enabled a lot of frictionless economic activity in the crypto space.

What is Impermanent Loss?

Impermanent loss happens when you provide liquidity to a liquidity pool, and the price of your deposited assets changes compared to when you deposited them. The bigger this change is, the more you are exposed to impermanent loss. In this case, the loss means less dollar value at the time of withdrawal than at the time of deposit.

An Example of Impermanent Loss

Consider our example of depositing 50% ETH and 50% UNI on Uniswap. When the price of ETH increases, it creates an arbitrage opportunity to make a profit at the expense of liquidity providers. Let’s say the price of ETH grows by 5%, here arbitrageurs can buy ETH on Uniswap at a price 5% lesser than the external market. The decentralized exchange (DEX) then rewards them for selling UNI for ETH until the ratio of both tokens is equal. It leads to LPs losing out on a portion of their liquidity deposited to a specific pool.

How to avoid the impermanent loss

In a volatile marketplace, the impermanent loss is almost guaranteed when staking cryptocurrency assets within a standard liquidity pool. Exchange prices are always going to move. However, there are ways that the effects of impermanent loss can be mitigated.

Trading fees

Trading fees are collected from traders using the liquidity pool and a share of those fees are then rewarded to liquidity providers. These fees are sometimes enough to mitigate and offset any impermanent loss. The more trading fees collected, the less impermanent loss there will be. Past a certain point, if a pool collects enough fees an investor will have gained more from staking assets in a liquidity pool compared with holding them.

Low volatility pairs

Impermanent loss is likely to occur for the most volatile cryptocurrency pairings. However, the impermanent loss can be mitigated by choosing a cryptocurrency pairing where the exchange price is not volatile. Therefore, significant price movements between the pair are unlikely. If price volatility does not exist, the impermanent loss can be avoided.

Complex liquidity pools

One of the main reasons for impermanent loss is due to the 50:50 split that is required by most liquidity pools. To overcome this issue, some decentralized exchanges such as Balancer offer users a variety of liquidity pool ratios. They also offer pools with more than two digital assets. Price changes in pools that have a higher ratio, such as 80:20 or 98:2, do not result in as much impermanent loss when compared with pools that have a 50:50 split.

One-sided liquidity pools

Impermanent loss occurs in a standard liquidity pool where two different cryptocurrency assets must be deposited. However, some exchanges such as Bancor have developed liquidity pools that offer users the opportunity to stake only one side of the pool. The other side of each liquidity pool on Bancor is made up of the native Bancor token, BNT. 

Bancor has also recently integrated price feeds via the decentralized oracle, Chainlink. By tying liquidity pools with a live market price, they can automatically adjust when significant price changes occur. This is not possible in standard liquidity pools.

Other things you need to know about impermanent loss

While the basics of impermanent loss have been covered, there are a couple of extra details that are worth knowing before staking liquidity in DeFi protocols.

Impermanent loss can occur regardless of price direction. An investor can only withdraw digital assets that have not suffered an impermanent loss if the exchange price happens to be exactly the same at the time of withdrawal.

Secondly, an impermanent loss is only realized when funds are withdrawn. It is “impermanent” because prices could return to the initial exchange price at any time. If prices returned, the impermanent loss would no longer exist. The loss is only permanent if an investor withdraws their funds from the liquidity pool.

Bottom line

The incentives for liquidity providers in the DeFi sector are strong. However, they are strong for a reason. Each protocol needs to provide users comfort that they will not lose out to impermanent loss. While an impermanent loss is inevitable when staking liquidity in standard liquidity pools, there are alternatives that investors can use to mitigate the risk.

Those new to liquidity provision should stick with low volatile cryptocurrency pairings or stablecoin liquidity pools. Alternatively, investors can utilize some of the more complex liquidity pools to mitigate the impact. For the more advanced cryptocurrency user, yield farming techniques can be implemented to ensure returns always stay far ahead of impermanent losses.