Becoming a Market Maker is now within the reach of anyone with funds thanks to numerous DeFi protocols such as Uniswap, SushiSwap or PancakeSwap that have enabled a veritable explosion of volume and liquidity. Thanks to these protocols, any user can earn trading commissions by providing liquidity to these platforms. The democratization of market making has greatly contributed to frictionless economic activity in the cryptocurrency industry.
Therefore, in this article we will tell you all about Impermanent Loss and how these platforms work. The “impermanent loss” occurs when the price of the tokens changes with respect to the moment when we had deposited them in the pool or liquidity reserve. The relationship between the change and the loss is proportional because the greater the change, the greater the loss. Although being a liquidity provider in a liquidity pool could be profitable and earn us income, we must always bear in mind the concept of impermanent loss.
An impermanent loss occurs when we contribute liquidity to a liquidity pool (e.g. Uniswap) and the price of the deposited asset changes during the time it has been deposited, causing us to lose money compared to having holdied that asset.
It is worth noting that those stocks that have assets held in relatively narrow price ranges tend to be less exposed to impermanent loss. An example of this is stablecoins or the many wrapped versions of a currency (e.g. Wrapped Bitcoin). These versions will remain in a relatively manageable price range. In this case, the liquidity provider (LP) will run a lower risk in terms of going through an impermanent loss. You may ask yourself after learning about this risk: Why would someone who stands to lose so much capital still risk offering liquidity? The answer is clear; the pool trading fees can offset these losses.
An example of this would be Uniswap stocks that are usually quite exposed to impermanent loss and yet can still be profitable due to trading commissions.
In the case of Uniswap, a 0.3% fee is charged for each trade. This percentage goes directly to the liquidity providers. If a large volume of trading takes place in a given pool, it is probably profitable to provide liquidity even if the pool is heavily exposed to impermanent loss. However, profitability will also depend on other elements such as the protocol, the assets deposited, the pool itself or general market conditions.
To better understand this concept, ideally, let’s give an example of in which case this impermanent loss would occur in a liquidity provider. Let’s imagine that Elena has just deposited a total of 1 ETH and 100 DAI in a Uniswap liquidity pool. To make the calculations easier, let’s imagine that at the time Elena made the deposit 1 ETH equaled a total of 100 DAI. Recall that in most AMMs the token pair deposit must be equivalent in terms of dollar value. When the total value of both tokens is added together, taking into account that it is a 50:50, the total value deposited would be $200. Let’s assume that this deposit represents 10% of the total amount held in the liquidity pool and means that there will be about 1000 DAI and 10 ETH in the pool.
Now let’s imagine that the Chinese government rules in favor of ETH and it goes from being worth 100 DAI to being worth 400 DAI. In this case, arbitrage trades will add DAI to the pool and remove ETH in order to keep the ratio anchored to the real price. If so, 5 ETH and 2000 DAI will remain in the liquidity pool.
The problem would arise if Elena decided at that time to withdraw her investment from the liquidity pool. Let’s remember that this investment is equivalent to 10% of the total pool. That is, she would withdraw 10% in ETH (0.5 ETH) and 10% in DAI (200 DAI). Both tokens combined equal an actual total of $400.
This means that due to the impermanent loss Elena has stopped earning $100. If she had holde those initial 1 ETH and 100 DAI, instead of depositing them i5 Uniswap, she could have $500.
In short, this loss that Elena suffers when she decides to withdraw her funds from the pool is called impermanent loss. When a liquidity provider comes to invest large amounts of assets in a DeFi AMM it directly faces much more significant losses. In fact, most commonly we see hundreds of millions of dollars moving between transactions in these types of pools.
First of all, when we are going to be part of a pool as a liquidity provider, we should avoid cryptocurrencies that have high volatility rates. This is because the more volatile the assets in a pool are, the greater the possibility of suffering impermanent losses on your investment. This leads us to the fact that before joining a group the first thing to do is to know the market behavior of the group in which we want to participate. This means that we should invest in those groups that have the best track record in the performance of their assets.
Another option to avoid making large losses is to start investing small amounts in order to see how the market evolves. This option is ideal especially in recently formed pools. The ideal would be to know the performance of a given pool, in this way, if we suffer any impermanent loss it will not be highly significant. In addition, this advice will help us to test the security of the system and to know if the platform serves the investment purposes we want to achieve.
Another thing to keep in mind is that the impermanent loss occurs regardless of the direction in which the price changes. The only thing that matters is the price ratio relative to the time of deposit.