Understanding Impermanent Loss and How to Prevent It in Crypto Trading

Understanding Impermanent Loss and How to Prevent It in Crypto Trading

The concept of impermanent loss is not hard, even for someone entirely new to the crypto market. Merely dissecting the phrase, one can understand it to mean a loss that is not permanent. However, there is more to what impermanent loss means in the crypto sense of things beyond the obvious grammatical translation.

That said, let’s delve into the topic by first describing the underlying concept of impermanent loss in the crypto market.

Understanding Impermanent Loss

In addition to what was described earlier, an impermanent loss is used to describe the noticeable changes in liquidity investment from the point of deposit and withdrawal.

Notably, this type of price difference is negative and usually happens when the value (i.e. price) of a token deposited in a liquidity pool declines from the amount it was at the time of deposit. More so, the larger the change or difference in token value, the bigger the trader’s exposure to impermanent loss.

That said, although the term impermanent loss is a term used across all financial markets, it is also used in the crypto market and most commonly used among DeFi traders, particularly those involved in yield farming.

The reason why impermanent loss is common among yield farmers is that they are mostly required to either stake or invest in a reserved liquidity pool (LP), an attribute that is peculiar to a special kind of crypto market known as an automated market maker (AMM).

Although it can be highly profitable, providing liquidity to an LP also comes with great risk exposure, one of which includes impermanent losses, thus the need to understand the underlying concept. But first, what’s the relationship between impermanent loss and the automated market maker?

To begin with, Market Makers (regardless of the financial market) are generally responsible for injecting liquidity into a specific market and maintaining this position throughout a trading period, which could be an hour, day, week, month, and in some cases, a year or more.

In this context, a Market Maker is responsible for injecting liquidity into a DeFi protocol’s liquidity reserve where other traders (i.e. borrowers) can take loans, trade with it, and subsequently return alongside a prespecified interest.

While anybody can contribute to the funding of this liquidity reserve (or LP), interested investors instantly become market makers and are rewarded with the commission from trading fees as well as an expected annual percentage yield (APY) at the conclusion of each investment period.

That said, a market maker’s contribution to a liquidity reserve is fixed; however, depending on the type of crypto asset, the value can fluctuate over time, implying that there could be a massive loss or gain at the end of an investment period.

If a market maker stakes a highly volatile token like Bitcoin (BTC), Ethereum (ETH) or Solana (SOL), for instance, there is no guarantee of withdrawing the capital investment at the same value as when it was deposited.

Consequently, if the value of the deposited asset goes up, then a market maker can expect more profit at the end of the investment tenure. At the same time, if the value of the deposited asset declines, which results in impermanent loss as described earlier, then a market maker can envisage indirect losses.

On the contrary, if the market maker deposited a stablecoin like Tether’s USDT, USDC, or other wrapped tokens, the exposure to impermanent losses will be relatively contained, making this a perfect alternative for most investors.

You may also wonder why market makers still go on to invest their hard-earned money into non-stablecoin liquidity pools, despite knowing that they are exposed to different risks, including that of impermanent losses, in the event that the value of the deposited token drops below the original value at the time of investment. Well, you will get to find out about that as you read on.

How Does Impamanent Loss Happen?

Let’s put the above explanation into context for those who are still trying to grasp how impermanent loss could occur in the crypto trade. In this case, let’s assume a market maker invested in a non-stablecoin liquidity pool, e.g., Ethereum (ETH).

So, let’s say, by the time the market maker deposited in an ETH Liquidity Pool (NASDAQ:POOL), the value of the asset per unit was pegged at $500. Mind you, the value must be equivalent to the deposited token pair, which in this case would be 500 DAE.

If at the end of an investment tenure, the pegged value of the deposited asset has declined to $420, the impermanent losses would be the equivalent of the difference between the value at deposit ($500) and value at withdrawal ($420), which is then calculated as $80.

Interestingly, other factors are responsible for IL behind the scenes from a more technical perspective. Let’s try to explain what really happens without making the entire process too complicated to understand.

To begin with, it is important to emphasize that impermanent loss can lead to big losses (including a significant portion of the initial deposit). You will find out how as we explain further.

In this scenario, let’s assume hypothetically that a liquidity provider is meant to offer liquidity at a 50:50 ETH/DAI pool. As such, the LP would need to deposit 5 ETH and 500 DAI, where 1 ETH is equal to 100 DAI.

By the way, if the intended liquidity pool has $5,000 DAI in total assets with a 10% share rate (not interest rate), that would mean the liquidity provider is entitled to a 10% share of the pool, which amounts to about $500 DAI or the equivalent in ETH at the time of withdrawal. So how exactly does IL take place?

Liquidity Providers are susceptible to IL for many reasons, with the major reason being that they are entitled to a share of the pool rather than a definite quantity of tokens. Let’s say that the price of ETH increases to 400 DAI. And in the process, arbitrage trading could occur whereby traders may add more DAI to the pool while removing ETH until the ratio reflects the current price.

Keep in mind that AMMs lack order books, which suggests that prices are set using the default ratio between the two assets in the pool, in this case, 50:50, as noted earlier. Ironically, despite the pool’s constant liquidity ($5,000 DAI), arbitrage trading causes the ratio of its assets to vary with each withdrawal.

Ultimately, impermanent losses are regarded as such because no loss happens if the cryptocurrencies can return to the price (i.e., the same price when they were deposited on the AMM). In addition, liquidity providers get to be paid 100% of the trading fees, which helps offset the risk exposure to impermanent loss significantly.

How Do Market Makers Make Profit Regardless of Impermanent Losses?

There is more than one way by which a market maker can make a profit; this way, even when the value of the deposited crypto-asset declines, they almost do not run out of options to make a profit off their investment.

Besides generating an agreed APY by default, market makers also earn commissions from trading fees, which are proportional to their capital investment. However, the percentage of commission earned varies across different platforms. For instance, Uniswap charges 0.03% on every trade and pays them directly to liquidity providers.

So, depending on how heavily invested a market maker or liquidity provider is on a platform, they can make so much profit that surpasses and makes up for the impermanent losses. On the contrary, if the value of the deposited crypto-asset rises, then market makers tend to make so much more profit than envisaged at the end of an investment tenure.

How to Prevent Impermanet Losses During Crypto Trade

The best way to prevent impermanent loss is to invest in stable crypto assets. However, in the case of non-stable crypto assets, investing for a short period could be a better option than a long-term investment. Also, you can consider DeFi protocol with a high commission rate and APY, which may cover any form of impermanent loss, if not all, at least to a significant extent.

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