There’s a hidden risk lurking in liquidity pools that every provider should be aware of: impermanent loss. This phenomenon can reduce returns even when liquidity providers (LPs) are earning trading fees. But what exactly is impermanent loss, and how can you manage it? Let’s break it down!
Understanding Impermanent Loss
What is Impermanent Loss?
Impermanent loss occurs when the value of your deposited assets in a liquidity pool changes relative to holding them in a wallet. This happens due to price fluctuations in the paired assets within the pool. The greater the divergence, the higher the loss.
The Mechanics of Impermanent Loss
Here’s how it works:
- When you provide liquidity to a pool, you deposit two assets in a 50/50 ratio (in most AMMs).
- If one asset appreciates or depreciates significantly compared to the other, the AMM adjusts the balance of tokens to maintain the constant product formula.
- This results in an opportunity cost, meaning you would have been better off just holding the assets instead of providing liquidity.
Real-Life Example
Imagine Alice deposits 1 TON and 2,000 USDT into a liquidity pool (assuming TON is worth 2,000 USDT). Her total deposit value is 4,000 USDT.
Now, let’s say TON’s price rises to 3,000 USDT. The pool’s AMM rebalances the ratio of TON and USDT to maintain equilibrium. Alice now holds less TON than she originally deposited. When she withdraws her funds, she might receive 0.87 TON and 2,610 USDT, totaling 4,200 USDT.
At first glance, this looks like a profit. However, if Alice had just held onto her 1 TON and 2,000 USDT outside of the pool, her total balance would be worth 5,000 USDT. The difference? That’s impermanent loss!
The Causes of Impermanent Loss
1. Price Volatility
The more volatile an asset pair, the more impermanent loss you risk. Highly correlated assets (such as stablecoins or wrapped assets like wBTC and BTC) experience less divergence, resulting in lower impermanent loss.
2. Liquidity Pool Dynamics
Automated Market Makers (AMMs) rely on mathematical formulas to facilitate trades. These pools don’t have order books; instead, they adjust asset balances based on supply and demand, which can lead to price shifts that cause impermanent loss.
Impermanent Loss vs. Permanent Loss
Impermanent loss isn’t necessarily permanent!
- If asset prices revert to their original state before you withdraw, the loss disappears.
- However, if you withdraw while the price ratio remains skewed, you lock in the loss permanently.
Real-Life Example: If Bob provides liquidity to an TON/USDC pool and TON price fluctuates but returns to its initial value before he withdraws, he experiences zero impermanent loss. But if Bob withdraws when TON is 50% higher, his impermanent loss becomes permanent.
Strategies to Mitigate Impermanent Loss
1. Choosing Stablecoin Pairs
Liquidity pools consisting of stablecoins experience minimal price divergence, significantly reducing impermanent loss.
2. Selecting Correlated Assets
Trading pairs with correlated price movements (e.g., TON/tsTON) help minimize impermanent loss since their relative values remain stable.
3. Timing Market Conditions
Providing liquidity when the market is stable or during sideways trends reduces the risk of large price divergences that amplify impermanent loss.
4. Earning Fees to Offset Losses
DEXs reward LPs with trading fees (e.g., 0.2% per transaction on STON.fi). In high-volume pools, these fees can compensate for impermanent loss, making liquidity provision profitable despite the risks.
5. Using Impermanent Loss Protection
Some platforms like STON.fi offer impermanent loss protection, where LPs receive insurance against losses after a set period of staking.
Tools and Resources for Liquidity Providers
To stay ahead of impermanent loss, here are some tools to monitor and manage risk:
- Impermanent Loss Calculators: Estimate potential losses before providing liquidity (e.g., STON.fi’s Impermanent Loss Calculator).
- Liquidity Pool Dashboards: Track real-time pool performance (e.g., Dune Analytics or DefiLlama).
Wrapping Up
Impermanent loss is a critical factor every liquidity provider should understand before diving into DEX liquidity pools. While it can reduce profits, using smart strategies such as selecting the right pairs, timing your entries, and leveraging fee earnings can mitigate its effects.
