What is impermanent loss?
- Impermanent loss refers to a situation in which an individual provides liquidity to a liquidity pool on a DEX and the price of the deposited assets change compared to when the assets were provided.
- Impermanent loss increases the more an asset’s price changes relative to its pair.
- Impermanent loss can be counteracted by trading fees.
What is impermanent loss?
Impermanent loss refers to a situation in which an individual provides liquidity (meaning two types of cryptocurrencies) to a liquidity pool and the price of the deposited assets change compared to when the assets were provided. The greater the change of asset value the greater the exposure to impermanent loss. If one is impacted by impermanent loss it means that the dollar value of assets at the time of withdrawal is smaller than at the time of deposit.
Pools with assets that stay within a smaller volatility range will be less exposed to impermanent loss. Stablecoins for example, will stay within a very limited price range and therefore carry less risk of impermanent loss for individuals that provide liquidity.
How to calculate impermanent loss?
There are a lot of detailed math heavy explanations out there on how to calculate impermanent loss. There is a formula that can be used to calculate it, but in short, impermanent loss increases the more an asset’s price changes relative to its pair.
This graph shows that impermanent loss happens whether prices go up or down. But the risk of impermanent loss is much greater as a token’s price depreciates. This is the reason why many liquidity providers tend to look for token pairs that are likely to increase in value at a similar rate over time.
Want to calculate impermanent loss?
The reason many find it difficult to spot impermanent loss is because it is quite complex to keep track of all resources needed. A full assessment of impermanent loss requires multiple data points. To properly calculate the profit and loss for a liquidity position one needs data on:
- Each token’s price at the time of deposit
- The amount of each token deposited
- The date of deposit
- The rate of reward for the liquidity pool
- The estimated price of each token at the time of withdrawal
- The date of withdrawal
- LP token yield farming strategies & interest earned
Thankfully, individuals do not need to manually calculate their impermanent loss, as there are plenty of calculators out there. To provide one example you can use this calculator to calculate your impermanent loss.
Why do people provide liquidity if at risk of impermanent loss?
Impermanent loss can be counteracted by trading fees, in fact even very volatile pools on Uniswap that are heavily exposed to impermanent loss can be profitable due to trading fees that are generated by the protocol. Uniswap (and also HeliSwap) charges a fee of 0.3% on every single trade, which is redistributed to all liquidity providers. That means that the greater the trading volume in a pool, the more fees it can generate and redistribute to liquidity providers. The profitability is determined by the protocol, the assets within the pool, and wider macro-economic conditions.
What about impermanent loss during the HeliSwap’s Community Lockdrop?
Generally speaking when an individual becomes a liquidity provider one needs to provide two types of assets and is then exposed to the impermanent loss once the asset prices change.
In the case of HeliSwap’s Community Lockdrop, impermanent loss can still occur if the prices of assets change relative to the pair. The difference to providing liquidity on Uniswap for example, is that for the lockdrop participants have only contributed HBAR (therefore only contribute 50% of the LP-Pair). The other 50% of the LP-pairs come from the HeliSwap team.