What is Impermanent Loss??

June is an investor looking for new investment options in the crypto space. After reviewing the many options available to her, she decides to put some of her crypto assets into a Decentralised Finance (DeFi) protocol and become a liquidity provider (LP).

June invests 10 ETH into her chosen DeFi protocol. Because of the protocol's design, she has to convert half of her 10 ETH into another cryptocurrency - a stablecoin - and put both tokens into the protocol as a pair.

June's chosen cryptocurrency pair will then form a part of a liquidity pool from which she can earn profits. This is called yield farming.

At the time of providing liquidity, 1 ETH was worth $1,000, meaning Jane had invested a total of $10,000 in the liquidity pool.

Remember that she converted half of this money into a stablecoin. In June's case, her chosen stablecoin is DAI. So, she invested $5,000 worth of ETH (5 ETH) and $5,000 worth of DAI (both tokens in the pair have to be of equal value).

Fortunately for June, she entered the market at the perfect time, right on the cusp of a bull market. Within two weeks of investing in the liquidity pool, the value of ETH quadrupled to $4,000. June was now sitting on a tidy 300% markup. Or was she?

Arbitrage

The design of most liquidity pools mandates that equal amounts of each token in a pair be equal. Therefore, the increase in the value of ETH means that ETH tokens must be taken out of the pool to match the total value of the stablecoin in the pool.

Assuming the total value of the ETH and DAI present in the pool Jane invested in are 50

ETH ($50,000) and 50,000 DAI, that's a Total

Value Locked (TVL) of $100,000 at the time of Jane's investing. However, because of the increase in the value of ETH, the 50 ETH present in the pool is now worth $200,000, which greatly exceeds the value of DAI present in the pool. Something needs to be done about this.

This is where arbitrage traders come in.

Because the liquidity pool requires that both tokens in the pool be of equal value, some ETH will be taken out of the pool, and some DAI added to the pool by arbitrage traders to equalize the value of both tokens. So now, we have 25 ETH (now worth $100,000) and 100,000 DAI in the pool. Balanced - as all things should be.

Impermanent Loss

Now that the value of June's liquidity pool has doubled, so has the value of her investment.

Now, her initial investment of 10 ETH (worth $10,000 at the time) is worth $20,000. On the surface, this looks like a tidy profit, but how much would she have if she just held the $10,000 she invested?

June invested 10 ETH at a time when 1 ETH was worth $1,000. Now that 1 ETH is worth $4,000, she would have had $40,000 if she had just held on to her ETH without investing in the liquidity pool.

The $20,000 loss that June incurred is called

Impermanent Loss. It is termed "impermanent" because the loss does not become permanent until an investor pulls their investment. As long as Jane leaves her money in the pool, the amount of impermanent loss will continue to change as the price of ETH changes, and may even vanish altogether if the price of ETH returns to $1,000.

Conclusively

Impermanent loss is almost inevitable when providing liquidity. No matter the direction of the price movement of the tokens one invests in a liquidity pool, the process of arbitrage ensures that one is still susceptible to impermanent loss. The larger the price difference from the time of investing, the larger the impermanent loss.

However, these losses are often offset by the money a liquidity provider earns from transaction fees as a reward for providing liquidity. Being a concentrated pool of funds, traders would often try to buy and sell cryptocurrencies within a liquidity pool. Each transaction is charged a fee that is then shared among all the liquidity providers. This is what makes yield farming an often profitable venture regardless of impermanent loss.