• Harsha M

Impermanent Losses

DeFi protocols like Uniswap or SushiSwap, have seen an explosion of volume and liquidity. These liquidity protocols enable essentially anyone with funds to become a market maker and earn trading fees. Democratizing market-making has enabled a lot of frictionless economic activity in the crypto space.

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.

Since the price of tokens relies on the ratios of their liquidity pools their prices can separate from the prices on other exchanges. If the price of ETH increases by 100%, now worth $200 per ETH, the liquidity pool would have changed to 7.071 ETH and 1,414.21 USDC. This is because the ratio of the pool has changed, it is no longer 50/50, which affected the price of ETH.

Since the liquidity provider has a 10% share of the liquidity pool, they can withdraw 0.7071 ETH and 141 USDC, which equals $282. However, if the liquidity provider simply held their 1 ETH and 100 USDC, they would be worth $300. The difference between the two, $18, is the amount of impermanent loss the liquidity provider experienced. A greater change in the ratio of the pool will result in a larger amount of impermanent loss.

Impermanent loss is based on sheet value, meaning it can keep changing until an action is taken. When you decide to withdraw after a price change, your loss will become permanent.

Below Impermanent Loss Calculator provides the expected losses when the user withdraws the liquidity:

The below picture depicts 20% losses between providing liquidity and withdrawing liquidity. So usually, I suggest providing crypto to crypto liquidity only and not crypto to USD liquidity. This would reduce the risk of Impermanent losses.

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