As a part of risk management for DeFi traders, Impermanent Loss (IL) is an essential concept to understand before becoming a Liquidity Provider on a decentralized exchange (DEX).
Impermanent Loss - The Basics
- Impermanent Loss (IL) is a risk-based side effect of AMMs.
- IL involves fluctuating price ranges on asset pairs in DEX liquidity pools.
- Sometimes losses may be offset by trading fee earnings.
- Losses only accrue when assets are withdrawn from the pool.
- Quadency DEX features other ways for Liquidity Providers to offset IL.
Impermanent Loss Explained
When providing liquidity to a liquidity pool, impermanent loss refers to the difference in token price between when you first deposited tokens into the pool and when you withdraw the tokens. The bigger the price difference, the more a liquidity provider is exposed to impermanent loss.
How Impermanent Loss Happens on a DEX
Providing liquidity means you are depositing two different tokens in equal value, i.e. 1 ETH:3000 USDT. If one side of the token pair has grown or contracted, the ratio may temporarily change, i.e. to a 60:40 ratio.
It is at this transitory moment that arbitrage traders come in to purchase the one asset at a discount, taking advantage of the transitory ratio imbalance. The arbitrageurs end up balancing the pool with their actions. Because of the rebalancing, the number of tokens for each of the token pair assets in a pool changes (even as the values have remained the same).
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Generally, the algorithmic formula for liquidity providing is:
x*y = k whereas:
- x is the amount of one of the crypto’s in a liquidity pool
- y is the amount of the other crypto asset
- k is the total liquidity in that pool
How it works: Example of Impermanent Loss
- Say a Liquidity Provider stakes 1 ETH and 3000 DAI in the ETH/DAI pool on SushiSwap.
- ETH is priced as 3000 DAI (or roughly $3000).
- The next week, ETH price goes up to $3500, now worth 3500 DAI.
- The Liquidity Provider withdraws their DAI tokens, still worth $3000 each.
- If they had simply held their ETH in a wallet, it would be worth $3500
- Impermanent loss would equal $500 or 30%.
- On average, LPs earn between 2% and 50% APY from trading fees.
- In the above example, if an LP earned 25% APY from trading fees, they still would have earned 5% in fees, to offset the impermanent loss and make a little yield.
In the example above, we used the stablecoin DAI. When token pairs do not include a stablecoin, liquidity providers may be at a greater risk of impermanent loss since greater volatility is associated with non-stablecoins.
Why are the losses “Impermanent”?
- Losses through IL are “impermanent” because they may be temporary - prices may recover to their original value before the liquidity provider withdraws the tokens, but of course whether or not that happens is highly speculative.
- Losses do, however, become permanent once the LP withdraws their tokens following a big price swing between the two pooled assets.
Impermanent loss may (or may not) be offset by trading fees. Generally, the more trading volume of the assets in question and the less price volatility, the less likely you are to experience impermanent loss. This is because trading fee revenue will generally be high enough to offset the IL.
DEXs like Quadency Exchange provide additional rewards to liquidity providers, beyond trading fees! Learn more.
Navigating Impermanent Loss on Quadency DEX
When Providing Liquidity for QUAD pairs on Quadency DEX, liquidity providers have access to the following LP features:
- Quadency DEX provides additional rewards to its Liquidity Providers. 228,571 QUAD tokens are shared with LPs every week, over and above trading fees.
- Pools include QUAD/ETH and QUAD/USDT.
- As an asset, QUAD is a high performance utility token with a proven business model, a long term strategy, vesting, a burn strategy, and a transparent team to back up the token (unlike many meme tokens that are merely a speculative token and nothing else).
- DEX Trade the Simplified Way with Quadency
- Provide Liquidity to Earn QUAD Tokens
- Discover the QUAD token!
Quadency is a cryptocurrency portfolio management platform that aggregates digital asset exchanges into one easy-to-use interface for traders and investors of all skill levels. Users access simplified automated bot strategies and a 360 portfolio view with a free account.
Disclaimer: The content of this article is for general market education and commentary and is not intended to serve as financial, investment, or any other type of advice.