Automated market makers (AMM) create liquidity pools generally consisting of two separate cryptocurrencies. When you deposit crypto assets in an AMM liquidity pool and the price of those assets decrease in value, you incur an impermanent loss. It is called impermanent loss because the exact amount of your loss can only be determined after you withdraw the assets from the liquidity pool. Any loss before the withdrawal will be temporary as the price can change and allow you to recover or reduce your losses.

Calculating Impermanent Loss

The pairs in the liquidity pools are usually ETH-based and stablecoin such as DAI or USDT in a 50:50 ratio. A depositor must place equal amounts of both currencies in a liquidity pool. 

Let’s understand this with an example.

Let’s say an ETH is equal to 100 USDT, and you deposit 1 ETH and 100 USDT in an ETH-USDT pool consisting of 1000 USDT and 10 ETH. You’ll own 10% of the entire pool after this deposit.

If the price of ETH then rises by $20 in the global market, making 1ETH = 120 USDT, traders would then rush in and use USDT to buy ETH (which is below $120 inside the pool) until the ratio within the pool reaches the new equilibrium at the new price of ETH ($120).

Your 10% stake in the pool would now be 0.912 ETH and 109.54 USDT. If you withdraw these funds, you can get $219.54, which is more than the $200 initial investment. However, the interesting thing is that if you didn’t invest these funds and simply held them, you would have made $220.

This shows that despite the price of ETH going up, you lost $1. This was an impermanent loss until you withdrew the funds. After the withdrawal, it became realized loss. This loss could’ve been significant if the price had decreased.

Avoiding Impermanent Loss

• If you are anticipating higher volatility, then you could choose to wait out the turbulent period to avoid impermanent losses.

• More trading fees would mean lower chances of impermanent loss. Trading fees in liquidity pools that are usually paid to liquidity providers can often help users offset the impermanent loss. 

• If you desire stability, you could select pools with stablecoin pairs such as DAI and USDT. This will help you avoid impermanent losses, but you’ll also be missing out on profits from a significant price rise in the markets.

Conclusion 

Impermenanet loss associated with liquidity pools is an important factor in DeFi. Understanding this concept will help you factor in the risks associated with being a liquidity provider, which in turn would significantly decrease the possibility of you experiencing impermanent loss with your deposits.

If you want to learn more about crypto investments, then read our article on portfolio diversification here.

Suleman Arshad

Suleman is a part-time crypto writer and full-time book addict. He holds a master’s degree in Chemical Engineering. Nothing excites Suleman like a well-organized fundamental analysis for long-term investment.