Impermanent Loss Explained

4 minute read

This video helps people understand what Impermanent Loss is and asks key questions when considering your exposure to Impermanent Loss. If you are new to liquidity pools, check out my video explaining it.

Impermanent Loss (IL), or in simple speak, not yet a permeant loss, is one of the hardest concepts in Defi for most people to understand. See the video below.

The Risk

Impermanent Loss (IL) is a risk Liquidly Providers have when staking their assets in a liquidity pool. It is the potential difference in gains between holding and being a Liquidly Provider.

Most people seem to freak out about it because it sounds scary, it is hard to understand and to explain.

A few things that need to pointed out here.

  1. The ‘loss’ is on paper only, and is not final - hence not yet permanent - it will likely change tomorrow e.g. BNB could go back to it’s original price and therefore there will be no IL. It becomes permanent when you withdraw from the Liquidity Pool.
  2. If both assets rise in price by the same percentage - than it is all good - the total pool value increases. The issue occurs When it is lop sided, or the pool becomes out of balance.
  3. Price will always change so the amount of IL or the amount you are ‘missing out’ on is always changing.
  4. The fees you get paid as a Liquidity Provider may have been more or less than what you missed out on, you need to take away any fee revenue from what you missed out on to understand your actual or net loss/gain.

So why do it?

Why become a Liquidity Provider if I am exposed to the risk of Impermanent Loss?

AMM platforms like BepSwap (ThorChain) need Liquidity Providers to operate, so they make it very lucrative for Liquidity Providers by giving them a good share of the fees, offering them additional ‘network benefits’ and some provide additional tokens for providing liquidity, which also have value. It is a risk many are willing to take as handsome rewards are on offer.

It must be said, however, the more the price moves, the more IL becomes an issue, and the IL can be greater than the income generated by fees or network benefits.

Or put another way, when price movements are small, generally the income generated is more than enough to cover the Impermanent Loss but when price movements become very large, it may not be.

Key questions to ask yourself:

  1. What are you trying to achieve? e.g. hold assets in the hope they will go up - trying to somehow capitalise on every potential price increase OR provide a service and get paid for it - and not worrying too much about trying to get every potential temporary price increase.
  2. What is your time preference - are you in it for the short term or the long term? Are you interested in short trading OR long-term asset appreciation and not concerned with short term volatility?

Remembering Impermanent Loss only becomes permanent when you withdraw!

Summing up

Impermanent Loss (IL) or in simple speak, not yet a permanent loss, happens during the rebalancing process of the liquidity pool, which is caused by price movements. It is a risk Liquidly Providers have when staking their assets in a Liquidity Pool. The more the price moves (e.g. the more the liquidity pool becomes out of balance), the more IL becomes an issue. AMM platforms need Liquidity Providers to operate, so some may give benefits/rewards to Liquidity providers (particularly when they are new).

I don’t know your situation or what is best for you, whatever you decide to do, I hope you have a better understanding of IL.

Bonus - not in the video

Arbitraging - how it works?

How is this magic rebalancing process done when a pool becomes out of balance? When you stake into a Liquidity Provider, it is done at the market price - like the retail price. But once in the pool, assets have their own price, let’s call it the pool price. When there is an imbalance in the pool, due to price movements, the price of the assets (pool price) become different to the market price to encourage people to buy or sell assets in the pool to bring it back into balance. This is known as an arbitrage.

Quick example

Say there is a BNB:RUNE pool and the price of BNB rises - the pool becomes out of balance.

To rebalance the pool, some BNB needs to be removed so the pool returns to a 50 / 50 split and this is done by putting BNB on sale, e.g. allowing the traders to buy BNB at a discount, or below the market price. Remember, that Liquidity Pools can set their own price, known as the pool price. Someone can basically buy the cheap BNB from this pool, then sell it at retail and pocket the difference. This is known as an arbitrage - and there are computer bots that do this all the time, so the rebalancing is kind of an automatic process. Bots may have to work on a pool for a period of time, first making big trades, then getting smaller till balance is restored. Bots do this as they get to pocket the Impermanent Loss.