Introduction

Risk and uncertainty are major characteristics of any financial environment, and the crypto space is no different. For participants in the decentralized finance (DeFi) sector, the concept of automated market maker (AMM) protocols and liquidity pools (LP) is necessary for decentralized exchanges (DEX) and traders to conduct trades.

These LPs and AMMs are usually supported by liquidity providers who choose to participate by providing liquidity and earning rewards. Yet, these assets or liquidity provided are susceptible to impermanent loss, which they wouldn’t have incurred if the assets had been held in the wallet instead.

Understanding the concept of impermanent loss is very important for participants in DeFi ecosystems because of its effects on user profit, as users can provide X amount of assets to a liquidity pool and receive fewer assets upon withdrawal.

Automated Market Makers (AMMs) and Liquidity Pools

Automated Market Makers (AMMs) are smart contract platforms used as decentralized exchange (DEX) protocols that rely on mathematical formulas to ascertain the prices of assets. They allow users to trade digital crypto assets and swap between currencies at an algorithmically determined price without needing centralized bodies or permissive architectures.

This is possible through liquidity pools. Liquidity pools are smart contracts designed to hold crypto tokens that serve as a digital asset reserve or liquidity reserve to make these tokens available for speeding up transactions in DeFi markets and platforms such as DEXs and AMMs. These smart contracts are self-executing.

Each pool maintains a constant ratio of token pairs, such as 50 ETH and 50 DAI. When these tokens experience drastic price adjustments, the pools are adjusted based on the effects of market demand, and the liquidity providers are compensated through transaction fees that are proportional to their share of the pool.

While the allure of passive earning makes providing liquidity popular, the practice is not without downsides. One such downside is impermanent loss, which occurs when the value of assets held in the pool deviates from the value of assets held externally. Another disadvantage is smart contract vulnerabilities, leaving the users’ funds open to bad actors and hackers.

What is Impermanent Loss?

Impermanent loss is the opportunity cost of providing liquidity to a liquidity pool or automated market maker. Most liquidity pools allow traders to trade pairs, such as a stablecoin and a volatile coin, which require a balanced contribution of both assets.

The value of these assets is usually pegged at the inception of the contribution. When external market prices fluctuate, the ratio within the pool may experience deviation, which would be corrected by reducing the value of the assets to match the originally contributed amount, which leads to fewer or more assets depending on the nature of the price fluctuation.

This mechanism is due to the relationship between the prices of the two assets contributed to the pool by the user. As one asset in the pool experiences price appreciation relative to the other, the pool rebalances by selling the appreciating asset and purchasing the depreciating one. Consequently, liquidity providers suffer losses compared to holding the assets individually.

Example of Impermanent Loss Using DAI and ETH

An example is the popular DAI/ETH liquidity pair. When a user provides liquidity, the amount is expected to be similar in amount or value. For instance, $50 worth of DAI and $50 worth of ETH. If the price of ETH doubles relative to the DAI, the pool rebalances by selling the appreciating ETH and buying more DAI tokens. As a result, when the user withdraws funds, they would receive fewer of the appreciating ETH tokens than they initially deposited, leading to an impermanent loss.

If the user had chosen to hold both tokens individually in a wallet, the value of the increasing ETH asset would be the profit earned on the asset, as opposed to the potential loss that exists as long as the funds remain within the pool, which is subject to further price fluctuations.

A popular misconception is that impermanent loss is guaranteed loss, which is an incorrect notion. The loss is only guaranteed when the user withdraws the funds from the pool. The inherent risk is the opportunity cost of potential gains foregone by providing liquidity instead of holding assets outright.

The formula used by the popular platform Uniswap is 2 * sqrt(price_ratio) / (1+price_ratio)-1. Calculating the impermanent loss on price fluctuation allows users to know how much liquidity remains from the initial investment and the financial value of the remnant based on the prevailing exchange rate.

DeFi users can also use the impermanent loss calculator from Dailydefi.org to determine the impermanent loss percentage.

How to Mitigate Impermanent Loss

The concept of investment strategies is to mitigate risks such as the potential risk of impermanent loss. By deploying these strategies, users minimize the exposure to price fluctuations within Automated Market Makers (AMMs) and liquidity pools.

Same-peg asset

One approach involves using the least volatile asset pairs that track the price of the same asset, which would reduce the price discrepancy. A popular example is stablecoins, which track the price of fiat currencies and reduce the possibility of drastic price changes.

Another example is using the wrapped version of an asset, such as stETH, that tracks the value of ETH on a 1 to 1 basis. By providing liquidity for a stETH/ETH liquidity pool, the price movement of ETH would be the same as that of stETH, which follows the same price.

The same logic also applies to two assets tracking the same volatile asset, such as RenBTC and wrapped BTC (WBTC), that track the value of Bitcoin.

Price Oracles

A price oracle is a smart contract tool used to view the real-time price of assets. Some AMM platforms use off-chain data to provide price information, which can be slower and ineffective for minimizing loss on price volatility.

On the other hand, price oracles can help mitigate these impermanent losses by providing accurate and timely price data on-chain, enabling arbitrage traders to continuously adjust the pool price until it reflects the real-world market value. This way, liquidity providers have a more precise valuation within pools and can avoid losing funds due to price fluctuations while still earning trading fees from the protocol.

Balancers

Balancers are upgraded AMM protocols that allow users to determine the extent of exposure they would experience from each token.

Traditional AMMs require the pools to contain two types of assets. The ratio has to be 50:50. To assist in mitigating loss, users who are bullish on one token over the other are allowed to increase the weight of exposure from 50:50 to 80:20 or 60:40, which means they are open to the volatility of one token while being shielded from the volatility and impermanent loss of the other token.

Using the example, if a user is bullish on DAI relative to ETH, they can join or create a pool with a high weight in DAI and a low weight in ETH. This way, when DAI goes up relative to ETH, they will keep most of the DAI upside while being protected from the ETH price movement.

While there are stablecoin liquidity pools on balancers that utilize zero impermanent loss mechanisms, not all balancers have these mechanisms that completely mitigate against impermanent loss.

Hedging strategies

Hedging strategies are risk management strategies used to offset losses in investments. Users can employ such hedging strategies as accumulating transaction fees from providing liquidity, portfolio construction, volatility indicators, and futures contracts and patiently waiting for the appropriate price combination to bring the impermanent loss to as close to zero as possible.

Conservative investors may opt for stablecoin pairs or platforms that implement impermanent loss protection protocols to minimize their risk exposure. At the same time, more aggressive strategies may involve concentrated liquidity provision and hedging strategies to capitalize on market opportunities.

An example is if a liquidity provider deposits assets in a 50:50 pool consisting of DAI and FLOW, expecting the FLOW to appreciate against the DAI, they can use a margin or options contract. This would involve buying FLOW with a strike price close to the price when the assets were deposited into the pool. This would ensure that in the event of a price rise, the user can profit from the option to offset any impermanent loss from the price rise in the liquidity pool.

To create a hedging strategy for the constantly evolving crypto space, diversifying investments, setting realistic expectations, and staying informed about market trends and regulatory developments are fundamental aspects of prudent risk management.

Conclusion

For Investors who aim to participate in decentralized financing, it is important to understand impermanent loss and how it affects the assets provided as liquidity for liquidity pools and automated market makers. While it is the opportunity cost on assets due to the volatility of the crypto market, it can be minimized or mitigated.

By leveraging strategies such as same-peg pairs, price oracles, portfolio reconstruction, and hedging techniques, users can minimize the exposure of their assets to impermanent loss.

Although impermanent loss becomes permanent when the user withdraws the assets from the liquidity pool, it is not the only risk associated with providing liquidity. Such risks include smart contract vulnerabilities and rug pulls, which require the user to conduct extensive research to safeguard against the inherent uncertainty of the crypto space.