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.

NOTE: ILP has been sunset in THORChain.

Impermanent Loss (IL), or in simple speak, not yet a permanent 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 face 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 and can be difficult to understand and 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. For example, BNB could return to its original price, eliminating the Impermanent Loss. The loss only becomes permanent when you withdraw from the Liquidity Pool.
  2. If both assets rise in price by the same percentage, then it’s all good - the total pool value increases. The issue arises when the price movements are lopsided or when the pool becomes out of balance.
  3. Price will always change, so the amount of Impermanent Loss or the amount you are ‘missing out’ on is always changing.
  4. The fees you receive as a Liquidity Provider may have been more or less than what you missed out on. To understand your actual or net loss/gain, you need to subtract any fee revenue from the missed-out amount.

So why do it?

Why become a Liquidity Provider if you are exposed to the risk of Impermanent Loss?

AMM platforms like BepSwap (ThorChain) require Liquidity Providers to operate, so they make it very lucrative for them by offering a good share of the fees, additional ‘network benefits,’ and sometimes additional tokens for providing liquidity, which also hold value. Many are willing to take this risk due to the attractive rewards.

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.

In other words, when price movements are small, the income generated generally covers the Impermanent Loss. But when price movements become very large, it may not be enough.

Key questions to ask yourself:

  1. What are you trying to achieve? Are you looking to hold assets in the hope they will increase in value, trying to capitalize on every potential price increase? Or are you providing a service and getting paid for it, not worrying too much about every temporary price fluctuation?
  2. What is your time preference? Are you in it for the short term or the long term? Are you interested in short-term trading or long-term asset appreciation, not being concerned with short-term volatility?

Remember, Impermanent Loss only becomes permanent when you withdraw!

Summing up

Impermanent Loss (IL), or in simple terms, not yet a permanent loss, occurs during the rebalancing process of a liquidity pool due to price movements. It is a risk Liquidity Providers face 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 Impermanent Loss becomes an issue. AMM platforms require Liquidity Providers to operate, so some may offer 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) becomes different from the market price to encourage people to buy or sell assets in the pool to bring it back into balance. This is known as 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, allowing traders to buy BNB at a discount or below the market price. Remember, 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 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 until balance is restored. Bots do this as they get to pocket the Impermanent Loss.