June 7 2021
DeFi 101

ELI5: Impermanent Loss

What Is Impermanent Loss

3 min read

<text-h2> Impermanent Loss (Yield Farming & Liquidity Mining)<text-h2>

Yield farming and liquidity mining are great investment opportunities. As a matter of fact, many liquidity providers continue to earn passive income despite the recent market downturn. However, there are some risks you gotta be aware of before diving in the pool — impermanent loss.

Impermanent loss is one of the most prominent risks in yield farming and that’s why you gotta stay informed about it. Impermanent loss describes a situation where the liquidity provider experiences a temporary loss of funds due to the price volatility of the trading pair. It also shows how much money the LP could have realized if they simply held on to their assets instead of locking them in the pool. Straight to the point, it’s the difference between holding crypto assets in your wallet and staking them in an Automated Market Maker (AMM).

Think of it this way,you got 1 apple worth $1000 and you decided to stake it in a farming pool so you could get more yields on it. However, to stake the apple in the pool you’d need an equal pair of 500 strawberries at $2 each to balance the apple price. Now you have 1 apple = $1000 and 500 strawberries = $1000. Staking these will provide with tokens and allow you generate yields over a period of time.

However, after staking, the price of apples shoots up to $2000. At the time you initially staked, it was worth $1000 now one apple costs $2000. If you decide to withdraw your stake at the current market price, your apple will be worth half the market price but you get extra 250 strawberries to balance out i.e. 0.5 apple = $1000 and 750 strawberries = $1500, a total of $2500. You may have gained extra strawberries but you lose on the worth of apples you could have had if you kept your apple. If you just held your apple and strawberries you would have 1 apple = $2000 and 500 strawberries = $1000, a total of $3000.

In DeFi, typically, two assets are often staked in liquidity pools, mainly stablecoins and a volatile cryptocurrency (say USDT and ETH). Now imagine this scenario, you as a liquidity provider stake equal amounts in value of USDT and ETH in the liquidity pool and suddenly the ETH price goes up. This would require arbitrage because the current market price of ETH does not match the price in the liquidity pool. Traders in the market would take advantage of this opportunity by purchasing ETH at a discounted rate to ensure an equilibrium is maintained between the ratio of USDT and ETH in the pool.

You may then end up with more USDT and less ETH after arbitrage occurs. Impermanent loss shows the amount you could have gained based on the current value of ETH if you had just simply held onto ETH rather than staking it. However, this loss is only temporary or imaginary unless you decide to withdraw your stake from the pool. The loss becomes permanent at this point. Although, if you decide to remain in the pool, and wait for prices to adjust back to the original state when you got into the pool, the loss could eventually cancel out but it’s still a risky road to take. Most times impermanent loss often becomes permanent and you lose part of your income.

If you gotta invest, then you gotta be prepared for the risks. So be sure to do an overall estimate of revenues and potential losses before locking your crypto assets in a pool.

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