2111 09192 Impermanent Loss in Uniswap v3

These higher ratios can also help to lessen the impact of impermanent loss by providing a lesser difference between holding the token compared to providing liquidity. Below you can see that being in a liquidity pool with 80% ETH and 20% another token performs better than the 50/50 ratio. Secondly, an impermanent loss is only realised when funds are withdrawn. It is “impermanent” because prices could return to the initial exchange price at any time. The loss is only permanent if an investor withdraws their funds from the liquidity pool. Suppose you have deposited an equal amount of ETH and DAI to an ETH-DAI liquidity pool on a Decentralized Exchange (DEX).

For instance, one of the most popular pools on Balancer is BAL-ETH, where the weight of the BAL side of the pool is 80%. This means that changes in the price of ETH (positive or negative) will not affect the pool that much compared to a 50/50 split. In any case, unless you are developing apps around Uniswap, k doesn’t really concern you.

In this very simplified example, you can see that IL happens whether prices go up or down. This causes many liquidity providers to look for token pairs that are likely to appreciate at a similar rate over time. For example, AMMs replace the order books of a centralised exchange with funds pooled by many users. A smart contract sets the price of each asset in the pool for traders, based on supply and demand.

  • So in this particular hypothetical, the LP would’ve faced just under 1% in the impermanent loss.
  • The name impermanent stems from the fact that the loss is temporary and can be recovered if asset prices return to their original state, which often does not happen.
  • This is because they now hold less ETH when compared to their initial deposit.

In fact, you may not actually lose any money, but rather your gains are less relative to if you had just left your assets untouched. By decentralising traditional financial services, anyone can now lend funds to DeFi applications. Depositing https://www.xcritical.in/blog/what-is-liquidity-mining/ digital assets, often into standard liquidity pools, can earn investors interest rates far above what is currently offered by global banks. Another way of fighting with impermanent loss was recently introduced by Bancor.

This is because the ratio of the pool has changed, it is no longer 50/50, which affected the price of ETH. Let’s say a liquidity provider adds 1 ETH and 100 USDC to the liquidity pool, this is for an equal value of both tokens. The dollar amount of their deposit is $200 because their ETH and USDC are both worth $100 each. Currently, there is 10 ETH and 1,000 USDC in the liquidity pool, a 50/50 ratio, which gives the liquidity provider a 10% share of the pool. They will receive LP tokens that they can use to redeem their 10% share of the pool at any time.

Bancor V2 pools can adjust their weights automatically based on the external prices coming from price oracles. This can completely mitigate impermanent loss even in the pools with volatile assets. In order to make profits, arbitrage traders take advantage of price differences across different exchanges to buy assets at lower prices and sell them at a higher price. For instance, when the price of Ethereum increases, traders can purchase ETH at a lower rate on one exchange and sell it for higher on others. Secondly, liquidity pools have a low market impact, as transactions tend to be smoother since they are based on an algorithm run by smart contracts. This same scenario will play out when the price of an asset decreases.

How tokenomics can affect the value proposition of a token

This guide will offer context to IL by explaining the technology behind automated market maker (AMM) liquidity pools. And it will detail the data resources needed to detect clues before loss occurs. However, if the funds are withdrawn from the liquidity pool before the assets’ prices return to their original levels, the impermanent loss becomes permanent.

Today, liquidity mining programs, in which governance protocols distribute tokens to their original liquidity providers, are widespread in DeFi. They provide these protocols with an easy way to decentralize governance, launch liquidity, and win the hearts of early adopters. The invariant increases from each swap due to the protocol fee and NFT delta, so impermanent loss improves with more volume. Here is an example comparing IL from price changes if the LP was just added and after an additional volume equal to the pools TVL. This difference between holding two assets and staking them in a pool is called impermanent loss. It is called that because the loss is not realized unless the stake is withdrawn.

Project Hydra could be a genius long term strategic move if executed correctly, and could completely eliminate the need for liquidity incentives. As an added complication, the risk and reward is different for every token https://www.xcritical.in/ pair depending on each one’s volatility. To estimate the IL, you should also calculate the value of the assets if you had just held them. Where k is the price ratio of the two assets, with respect to price during entry.

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.

How to Avoid Impermanent Loss?

The user’s share is now 1.5 BNB and 40 CAKE, which equates to $100, but if this user held each asset individually, they would instead have $120. This is the impermanent loss in action, as arbitragers begin to buy CAKE with BNB, the pool shifts’ ratio, allowing the arbitragers to profit off the liquidity providers. Take note as liquidity pools centered around volatile assets are the biggest sources of IL risk. Liquidity pools are smart contract enforced deposits of two tokens needed to enable swaps on a DEX. These pairs are usually set at a 50/50 ratio (but there are also uneven liquidity pools). Keep in mind that liquidity pools around volatile assets are the most significant sources of IL risk.

In such a situation, the profits that arbitrage traders make will likely come at the expense of the liquidity providers. This is because they now hold less ETH when compared to their initial deposit. Sometimes, you might not lose your money, but the gains could be relatively less than expected.

Several informative articles elucidate the concept and offer examples, yet they consistently present a formula for impermanent loss without providing its derivation. Crypto assets like ETH are not pegged to the value of an external asset like stablecoins, so their value fluctuates based on market demand. Impermanent Loss (IL) is a phenomenon that was born along with the advent of decentralized finance (DeFi) and is the result of an algorithmic rebalancing formula using AMM protocols. Since market makers simultaneously hold positions on both the bid and the offer, if the market moves sharply in one direction, they make losses.

Leave a Reply

Your email address will not be published. Required fields are marked *