What is Impermanent Loss in Crypto? A Simple Explanation
Impermanent loss refers to the temporary loss in overall value if the prices of two assets in a liquidity pool diverge. In simple terms, the total value of the tokens in the pool is less than if you had held the assets in your wallet. The loss is due to the change in quantity for each token as prices deviate from the original ratio.
Any type of loss is bad, right? Not always. Impermanent losses can become smaller over time and can also be offset by trading fees in many cases. In this guide, we’ll explain how impermanent loss in crypto works as well as ways to mitigate the risk of impermanent loss in liquidity pool investments.
In Short: What is Impermanent Loss?
An impermanent loss (IL) is the change in the total value of assets deposited into a liquidity pool compared to just holding the tokens. Price divergences in two tokens relative to their starting values cause the loss. However, until you close the position, the loss is impermanent. The numbers will continue to shift based on price divergences until you close out the position in whole or in part.
In effect, it’s a paper loss until the pool funds are withdrawn, similar to unrealized losses on stock trades. However, other earnings, such as trading fees for the pool or farming rewards, can also offset the loss.
If you’re thinking about providing liquidity, it’s important to understand how impermanent loss occurs and how to factor the possibility of IL into your investment decision.
How Does Impermanent Loss Work? 6 Steps to Understand
The easiest way to understand how impermanent loss occurs is to use an example with dissimilar assets that we know will diverge in value. For example, we can use USDC, which is pegged to a value of $1 USD, and ETH, which fluctuates in price daily. The divergence in price between these two assets will cause an impermanent loss. A greater divergence creates a larger risk of IL.
1) Add Liquidity to a Pool
For this example, we’ll use Uniswap, a popular decentralized exchange (DEX) that supports nine leading blockchains, with dozens of code-copy forks that work similarly on smaller blockchains.
To mimic the functionality found on competing DEXs, we’ll choose the full range for the pool. This means the assets will be available for swaps at any price from zero to infinity.
It also requires a 50/50 split in the value of the pool assets. This ratio will persist throughout the trading range as the automated market maker (AMM) algorithm adjusts prices for pool assets to maintain a balance between the two assets.
To keep the math simple, we can deposit 1 ETH and $2975 in USD to match the current market price.
Now, we have a balanced pool with a value of $5,950. Let’s see what happens next.
2) Price Divergence
USDC will maintain its value of $1. However, ETH’s price will fluctuate, which then affects the quantity of tokens on both sides of the pool. The number of ETH tokens will adjust based on the price of ETH relative to USDC and the number of USDC tokens will also change as users swap USDC for ETH and vice versa.
Let’s assume that we leave the pool active for a few months, during which ETH rises by 30%. USDC doesn’t change in value; each USDC still equals $1.
However, it’s important to note that IL reflects the price divergence in either direction. If ETH goes up or down compared to USDC, there will be an impermanent loss.
3) Loss Calculation
Now, let’s see the difference in the value of the pool compared to just leaving the assets in your crypto wallet. Remember, ETH went up 30% in this example.
| Asset | Starting Value | Ending Value |
| USDC | $2,975 (2975 tokens) | 3392.02 USDC |
| ETH | $2,975 (1 ETH token) | 0.88 ETH |
| Total | $5,950 | $6,784 |
That’s a profit of $834. Nice work! But there’s still an impermanent loss. The gain could have been higher.
The net effect in this example is that you sold some of your ETH for USDC gradually, meaning you didn’t capture the full 30 percent gain.
If you just held the tokens, you would have an additional $58.46 (0.85%). You’ll have more USDC in this example, but your ETH holding went down from 1 ETH to 0.88 ETH, creating a net (impermanent) loss.
To calculate the impermanent loss, you would need to know the value of each token remaining and the amount of each you would have. An impermanent loss calculator can help you with the task and make math much easier. We’ll do a walkthrough on how to use one in just a bit.
The calculated example above also shows how swap fees can help offset IL, creating a higher overall profit compared to holding the assets in many cases.
4) Withdrawal Impact
We just saw where supplying ETH and USDC can create an impermanent loss compared to just holding the assets in your crypto wallet.
When you withdraw funds from the pool, you lock in the impermanent loss, permanently changing the number of tokens in each asset. To revisit the example from above, you now have 0.88 ETH compared to the original 1 ETH deposit. The USDC balance also changed, giving you 3,392.02 USDC compared to the 2,975 you deposited.
We also saw that the impact was minimal, leading to a loss of less than 1% in this example. However, the numbers can change dramatically depending on the amount of the divergence. Let’s say that instead of a 30% gain, the ETH price had a 300% gain, rising from $2,975 to $11,900.
Now the IL reaches 25% relative to the future value and is half of your initial investment in the pool.
5) The Temporary Nature of Loss
Impermanent loss hinges on the divergence of the price of the two assets in the pool and will create a paper loss whether prices go up or down. However, it’s just a loss on paper until you close the position. Until then, the IL amount will fluctuate based on shifting market prices. For some pairs, the loss could reduce or even become zero as the trading range moves. But IL is always a loss (or zero), never a gain.
If ETH falls from its 30% gain to a value of $2,975 again, the impermanent loss disappears. If the downward trend continues, IL returns, amplifying the loss due to the falling price.
Again, if the trend reverses, the IL is reduced, possibly reaching zero again.
6) Mitigating Factors
Impermanent losses aren’t always losses in the big-picture view, even if you close out the position and lock in the changes to token amounts. You can earn swap fees for providing liquidity, generating a yield of 1% up to several hundred percent, depending on the amount of swap activity, the percentage earned on each swap, and your share of the liquidity provided at that price point.
Study the platform and trading history to understand how yields work and whether they will stay in the current range. Invest some extra time studying the trade if yields are extremely high. A high yield could be a red flag.
Some decentralized exchanges also incentivize specific pairs, paying an additional yield in other tokens that add to your overall earnings and further offset IL.
Lastly, like all interest-based earning strategies, time plays an important role. Even in cases where your impermanent loss could be high, a long enough time frame (or a high enough interest rate on a shorter time frame) can outperform the IL in many cases.
How to Calculate Impermanent Loss: Step-by-Step
The impermanent loss formula to find the IL for a closed position follows a simple pattern we touched upon earlier.
The process calculates the value of the tokens in USD or your preferred currency if you had held them rather than using the tokens to provide liquidity.
First, multiply your starting quantity by the price when you close the position or the current price for open liquidity pool balances. To get the market values, check a popular exchange like Coinbase.
In this example, ETH was at $3,000 when the pool was funded and then rose to $4,000.
- USDC: 1000 x $1 = $1,000
- ETH: 0.33333 x $4,000 = $1,333.42
- Total: $2,333.22
Now, let’s say you removed the liquidity when ETH reached $4,000. We’ll use those quantities to calculate the new value of the pool tokens.
- USDC: 1,154.69 * $1 = $1,154.69
- ETH: 0.288675 x $4,000 = $1154.70
- Total: $2,309.40
Subtract the value of the tokens if you had held the original quantity from the value of the remaining LP tokens.
$2,309.40-$2,333.22 = -$23.82 (loss)
Knowing how the token quantities will change can be trickier, however.
Many decentralized exchanges, such as Uniswap V2, use the constant product formula to determine the price of a token within a liquidity pool. The formula is designed to keep the pool’s value in balance.
Constant Product Formula: X * Y = K
- X= Quantity of Token X
- Y= Quantity Token Y
- K= Constant (Quantity of Token X * Quantity Token Y)
So, DEXs are using an exchange rate rather than dollar amounts to calculate the amount of each token remaining after a swap. Prices are irrelevant to the formula other than how the two assets relate to each other, although arbitrage traders keep liquidity pool prices close to market prices.
In most cases, it’s much easier to use an impermanent loss calculator to calculate the IL for a pool position.
How to Use an Impermanent Loss Calculator
Calculating impermanent loss is an important part of being a liquidity provider. Several calculators can do the heavy lifting to calculate the impermanent loss for a position. We’ll use the calculator provided by CoinGecko for this example.
- Set the AMM model. We chose Uniswap V2 (50/50 positions). Automated market makers like Balancer can help reduce IL by weighting one side of the pool much heavier than the other, such as 80/20 or 95/5.
- Choose a percentage price change for Asset 1.
- Assign a weightage for Asset 1. This auto-populates based on the AMM you choose but can be handy if you need custom values for a Uniswap V3 pool.
- Choose a percentage price change for Asset 2.
- Assign a weightage for Asset 2. Use the automatic setting or customize.
In this example, Asset 1 increased in value by 10%, whereas Asset 2 increased by 300%. This can happen when pairing ETH with a popular meme coin, for example. The result was an impermanent loss of nearly 18% compared to just holding the two assets.
Factors That Influence Impermanent Loss
Impermanent loss is often described as an opportunity cost, meaning that you may lose an opportunity to sell the assets for more money. Several factors can play into affect how much impermanent loss you’ll experience as a liquidity provider, including volatility and trading volume.
Crypto Price Volatility
Changes in price are what create an impermanent loss. If the asset pair of the liquidity pools you choose always trades at a stable rate, there will be no impermanent loss. For example, if both deposited assets increase by 20%, you won’t have IL. However, if one goes down 20% while the other rises 20%, you’ll lose 2% to impermanent loss.
Volatility is the greatest driver of IL, and it’s often determined by the assets you choose for your liquidity pool.
Liquidity Pool Composition
Correlated assets have lower IL. For instance, WBTC and ETH have a nearly 90% price correlation. This just means these assets tend to move up and down simultaneously and by similar amounts.
However, the safest option is often to use stablecoins, which are pegged to $1. For example, you can provide liquidity for a USDT and USDC pair, both of which are valued at $1.
By comparison, meme coins and other volatile assets can create more risk for liquidity providers.
Trading Volume
Trading volume can play a role in that increased demand or selling pressure can trigger price divergence that creates an impermanent loss. Increased volume can also lead your pool to a loss faster, giving you less time to observe trading metrics for your pool.
Time Horizon
Time can cut both ways as it relates to IL. For some pools, if you wait long enough, the pool might return to a closer balance and reduce or eliminate your impermanent balance. In other cases, the longer you wait the worse the math becomes. This is particularly true for assets that are headed to the moon — or headed to zero.
How to Avoid Impermanent Loss
Several methods, including your choice of pools and diversification, can help you reduce your risk for IL. However, there is no way to remove all risk for impermanent loss outside of not supplying liquidity. Let’s consider some of the most common solutions that can reduce your risk.
Choose Stablecoin Pairs
Stablecoin pairs pegged to $1 make a solid choice if you want to earn passive income yield through liquidity mining but don’t want the higher risk that comes with most crypto assets. If the pool becomes unbalanced, the assets are still worth $1.
There is one primary risk, however. The stablecoin can lose its peg to $1. In 2023, USDC fell to $0.87. In 2022, UST, an algorithmic stablecoin, fell dramatically. UST now trades at less than $0.02.
Before choosing a stablecoin to store value while providing liquidity, research popular stablecoins to understand how they’re backed.
Diversification Across Multiple Pools
It can be difficult to predict which pairs may see more price divergence and, thereby, experience more impermanent loss. Using multiple pools to drive passive income can help distribute the risk. Although it’s still likely to see impermanent loss in more than one of your pools, the degree may be limited in some cases.
Some advanced strategies use price limits to create more efficient pools at specific price points and you can create multiple pools to accomplish your goals. For example, you can use Uniswap V3 to place one or more DeFi liquidity pools above the current trading price. This strategy creates a dollar-cost average exit strategy, assuming the price reaches the levels you’ve chosen and continues north. The same approach can help you average into a position by automatically buying the dips when prices fall into to range of your pool.
Monitoring Prices and Market Trends
Reducing impermanent loss often requires a watchful eye on the markets. Large price moves up or down relative to the paired asset are the cause of IL. It may make sense to pull your liquidity or reduce your exposure if you expect big price swings. However, a big price movement could also help bring parity to your trading pair. The theme here is to stay apprised of your investments so you can plan accordingly if news or events might cause price divergences.
DEX Choice
Many decentralized exchanges use a 50/50 asset mix, but Balancer uses an 80/20 mix, which can limit impermanent loss. The platform also offers 95/5 and 98/2 mixes for certain crypto assets. This strategy can reduce IL risk but may require more exposure to the higher-weighted assets in the pool.
Conclusion
Impermanent loss is best described as an opportunity cost, meaning you could see greater gains by simply holding rather than providing liquidity. However, swap fees earned along the way often offset IL and provide passive income on your crypto holdings.
Price divergence is what causes impermanent loss, so it can be helpful to look for opportunities to use similar assets or closely correlated assets to reduce impermanent loss and maximize your efficiency.
FAQs
What is impermanent loss?
Impermanent loss refers to the difference in value between holding assets or providing liquidity for the assets. The latter can result in a lower overall value, called impermanent loss, as token quantities shift due to swaps.
Why does impermanent loss happen?
Impermanent loss happens due to price divergences in the two assets held in a liquidity position. If one price stays stable while the other rises in value, the number of tokens in the pool will adjust to keep the two sides balanced. The result is a lower value compared to simply holding the tokens without providing liquidity.
How is impermanent loss calculated?
To calculate the impermanent loss, compare the market price of the token quantities you provided to the liquidity pool to the value of the tokens remaining after swaps in the pool.
Can you recover from impermanent loss?
Yes. In some cases, the two assets in the pool can move closer together as the market for each moves up or down. Impermanent loss isn’t due to just price changes but rather price ratios. As the pair approaches the original price ratio when deposited, i.e., 5:1 or 1:500, the impermanent loss for the pool is reduced.
References
- Impermanent Loss Calculator (coingecko.com)
- Stablecoin USDC breaks dollar peg after firm reveals it has $3.3 billion in SVB exposure (cnbc.com)
- Why Stablecoins Fail: An Economist’s Post-Mortem on Terra (richmondfed.org)
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