What is Impermanent Loss in DeFi Yield Farming And How to Avoid It
What it is and how it’s counted, what crypto is less exposed to impermanent loss and why impermanent loss is quite permanent
First of all — it’s not a new term. The phenomenon of impermanent loss is known as Constant Mix Strategy, and has been existing on the stock market since the very beginning.
On the traditional fund market constant mix strategy (CMS) helps to keep the liquidity pool balance in strictly adjusted proportion. At its core CMS is a constant rebalancing of the investment portfolio for maintaining a certain ratio of assets.
So impermanent loss is the price you pay for the investment strategy change — “constant mix strategy” to “buy and hold strategy”.
Well, but let’s keep talking about DeFi.
What is Impermanent Loss in DeFi
It is hard to explain in simple words.
Impermanent loss is a loss that funds are exposed to in a liquidity pool. It normally affects liquidity pools having the equal ratio of tokens — in 50/50 proportion, and happens when the ratio of assets in the pool becomes uneven.
Impermanent loss is a comparing of your crypto when it is in the liquidity pool versus its value in the wallet. It’s a less dollar value at the time of withdrawal than at the time of deposit.
Impermanent loss takes place no matter what direction the price of token changes.
Example: In 2019 you bought a car for $10,000 — and in a year this deposit earned you nothing. But if you spent $10,000 on ETH — in 2020 you’d have earned $40,000. Impermanent loss is $30,000.
Why Impermanent Loss Happens
As you remember everything is going on a platform of some decentralized exchange — which is Automated Market Maker (AMM).
AMM is ruled by math’s formulas, and the main one is pool pricing formula: X*Y=K (X, Y — different assets, K — constant value). This formula allows AMM to keep its autonomy, and at the same time causes impermanent loss in DeFi.
Users trade using a liquidity pool, and the ratio will change depending on how many tokens there are, and in turn it will affect the price of these tokens.
The term impermanent loss itself hints that the loss is impermanent, and if you wait a little — the ratio of assets will normalize. Moreover, liquid providers lose real money only when funds are withdrawn from the liquidity pool.
How to Count Impermanent Loss And Minimize Risks
The DeFi market is highly volatile, but even if the platform is heavily exposed to impermanent loss — it still remains profitable thanks to trading fees and rewards.
For example, Uniswap charges every trade for 0,03% and returns it as rewards to the liquidity providers. The higher the volume of trades — the more revenue is generated.
How much impermanent loss is — price change to loss:
- 1,25x = 0,6%
- 1,5x = 2%
- 1,75x = 3,8%
- 2x = 5,7%
- 3x = 13,4%
- 4x = 20%
- 5x = 25,5%
Note that impermanent loss doesn’t account for fees, slippages or time of stack formation.
If you have a fear of missing out — here are some solutions for you.
First you can use stablecoins to lessen impermanent loss. Stablecoins stay in a relatively contained price range, and can be less exposed to that kind of loss — but still can.
You can also reduce impermanent loss by using liquidity pools with ratios other than 50/50. There are many platforms that offer liquidity pools with ratios 60/40, 80/20 and even — 95/5. But the other side of such pools is a small number of users, and probably you get a little or no yield on your deposit.