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What is Impermanent Loss? Understanding How It Works and Its Risks in Crypto

If you’ve been involved with decentralized finance (DeFi) or liquidity pools, you’ve probably heard the term impermanent loss and wondered, what is impermanent loss? or how impermanent loss works. This concept is essential for anyone providing liquidity on automated market makers (AMMs) like Uniswap, SushiSwap, or PancakeSwap. In this article, we’ll explain impermanent loss, how it happens, and what risks it poses to liquidity providers.

What is Impermanent Loss?

Impermanent loss occurs when the price of the tokens you’ve deposited into a liquidity pool changes compared to when you first added them. The bigger the price change, the larger the potential loss. This loss refers to the difference in value between holding your tokens versus providing liquidity in a pool.

The term “impermanent” means the loss is temporary and can be reversed if token prices return to their original levels. However, if you withdraw your liquidity while prices have diverged, the loss becomes permanent.

How Does Impermanent Loss Happen?

Let’s look at an example to understand how impermanent loss works:

Imagine Alice deposits 1 ETH and 100 DAI into a liquidity pool where 1 ETH equals 100 DAI, so her total deposit is worth $200. The pool has a total of 10 ETH and 1,000 DAI, meaning Alice owns 10% of the pool.

Now, suppose the price of ETH rises to 400 DAI. Arbitrage traders will adjust the pool by adding DAI and removing ETH to reflect this new price. The pool now holds 5 ETH and 2,000 DAI, but the total liquidity remains $10,000.

When Alice withdraws her 10% share, she receives 0.5 ETH and 200 DAI, totaling $400. While this might seem like a profit, if she had simply held 1 ETH and 100 DAI, her holdings would now be worth $500. The $100 difference is Alice’s impermanent loss.

What is Impermanent Loss Risk?

Impermanent loss risk means that by providing liquidity, you might end up with less value than if you just held your tokens. This risk increases with the volatility of the tokens in the pool. Pools with stablecoins or assets that don’t fluctuate much have lower impermanent loss risk.

However, liquidity providers earn trading fees from swaps in the pool, which can offset or even exceed impermanent loss. For example, Uniswap charges a 0.3% fee on every trade, which goes directly to liquidity providers.

How to Estimate Impermanent Loss

Impermanent loss grows with the price divergence between the tokens. Here’s a quick summary of losses compared to simply holding your tokens:

• 1.25x price change = 0.6% loss
• 1.5x price change = 2.0% loss
• 2x price change = 5.7% loss
• 3x price change = 13.4% loss
• 5x price change = 25.5% loss

Importantly, impermanent loss occurs regardless of whether the price goes up or down; it depends on the relative price change.

Summary: What You Need to Know About Impermanent Loss

Impermanent loss is a fundamental concept for anyone providing liquidity to DeFi protocols. While it represents a potential risk, understanding how it works and using tools like impermanent loss calculators can help you make informed decisions. Remember, trading fees earned can offset losses, but high volatility pools carry greater risk.