TL:DR; passive retail LPs, could be losing A LOT of $$$ due to impermanent loss so they NEED to understand it.
Alice the Liquidity Provider
Put yourself in the shoes of Alice, a long term believer in Crypto. Alice bought a lot of ETH and USDC early on and wanted to support these growing protocols, so she deposited her assets in Uniswap as a Liquidity Provider (LP) back in 2018. She left them there as she watched the price of ETH 5x. Alice was delighted (as we all would be!), she had 5x’d her money on ETH right? WRONG. She had actually lost up to 25% of her capital vs. HODLing and not LPing.
Alice believed the same misconception that many of us do. She believed that providing liquidity in an AMM was like HODLing her asset with interest from transaction fees. Alice believed she would ride the upside when her tokens increased in value. And she did, but a lot less than if she had HODLed.
Alice could be you, or me, and the reason she lost money is because she didn’t understand impermanent loss. And it is not Alice’s fault. Impermanent loss is a deeply technical concept that most people don’t see in their day-to-day. There are many great technical explanations of impermanent loss like this but in this blog, we wanted to provide a more practical explanation.
What is Impermanent Loss (IL)?
Impermanent loss occurs when the prices of your tokens diverge whilst in a liquidity pool. It would be more appropriate to call it divergence loss.
It occurs because AMM liquidity pools have to maintain a fixed ratio (often 50% / 50%) of tokens (e.g. ETH-USDC) in a pool. For example, if we want to deposit 1 ETH @ $3,000, we will also have to deposit 3000 USDC @ $1 - $3,000 of each token.
Assuming no transaction fees (for now), IL can roughly be defined as:
By LPing, Alice’s payoff is maximized when the relative price of her tokens remains roughly constant, as you can see in Figure 1. The x axis shows the amount of price deviation. In other words, as prices change, Alice’s payoff begins to suffer. It is only at 0% price change (no divergence!) that Alice reaches the maximum payoff. Note that with transaction fees, the curve in Figure 1 will be shifted upwards.
How does impermanent loss occur?
TL:DR; When relative prices change, the # of each token changes so when we withdraw, we get back a different # of each token than we deposited.
- When we deposit tokens (e.g. ETH + USDC) in a liquidity pool, we receive LP tokens.
- LP tokens give us the right to a proportion of the assets in the liquidity pool.
- Liquidity pools are required by their trading function (e.g. Uniswap uses the Constant Product Market Maker, x * y = k) to keep a constant ratio of each asset (i.e. 50% ETH, 50% USDC).
- When the relative price of assets change, the number of each token in the pool changes to keep that constant ratio.
- When we withdraw, we get back a different number of ETH and USDC than we deposited, which, excluding fees, will be worth less.
Let’s look at an example of this process below.
ETH-USDC Example (No Transaction Fees)
- Scene-setting - in this example, the price of ETH doubles from $100 to $200, and USDC remains constant at $1. We start with $1,000 of assets, $500 of ETH (5 ETH @ $100) and $500 USDC (500 USDC @ $1). The AMM uses the Uniswap constant product trading function.
- The HODL Scenario is straightforward, we now own $1,500 of assets, $1,000 of ETH, (5 ETH @ $200) and $500 USDC, the same as before.
- In the LP Scenario, the pool must hold 50% of each asset, so as the ETH price increases, the pool sells ETH and adds USDC. This means we can withdraw $1414: $707 of ETH (3.54 ETH @ $200) and $707 USDC (707 USDC @ $1).
- Other AMMs, such as Balancer can hold a different ratio of assets in each pool. Take their 60% WETH, 40% DAI pool for example. This ratio is defined by their trading function.
Impermanent loss as a % of pool TVL is a rough approximation for what fees should be, over a fixed time period, for an LP to be profitable.
Why is it important?
TL:DR;…
If impermanent loss is greater than transaction fees on average, then it is not rational to provide liquidity, assuming no other benefits (e.g. liquidity mining, hedging). It can be hard to notice though because your assets may be increasing in absolute value, but losing relative value (to HODL).
How can LPing remain profitable?
- Become more sophisticated / active - easier said than done when you’re competing with institutional market makers!
- Protocol liquidity incentives can make up for impermanent loss.
This is important because Crypto needs profitable market making to retain composability. For example, Axie Infinity gave many people access to capital because they could swap AXS for ETH. They could only do this because LPs provided AXS-ETH. If the LPs didn’t think it would be profitable for them, then they wouldn’t LP their tokens, reducing composability.
Well aren’t liquidity incentives enough? Yes in the short term, but that is not a long term viable solution. It is a cash plug, like VC funding for unprofitable SaaS businesses. The question remains whether there will be a space for passive LPs in Crypto Market Making.
How bad is it?
TL:DR; not bad for small price changes, very bad for large price changes. If ETH 5x’s vs. USDC, you lose 25% of your capital vs. HODL.
The key takeaway is that impermanent loss is very small for small deviations in price (barely noticeable for +/- 5%) but starts to get quite large (1% of profit) as relative prices move +/- 25%. With meaningful price drift, these losses can be quite large.This takes us onto the next obvious question...
For which token pairs is impermanent loss most likely?
TL:DR; when token prices are volatile and uncorrelated - shitcoin + token (e.g. APE-ETH) and token + stablecoin (e.g. ETH-USDC) pairs.
Most impermanent loss?
- Shitcoin + token (e.g. LOOKS-ETH) pairs with a highly volatile token that increases/decreases in magnitudes of value.
Second most impermanent loss?
- Token + stablecoin pairs (e.g. ETH-USDC) with a fixed value stablecoin, and a token that changes in value. IL is much lower than for shitcoin + token pairs, given the price movement.
Existing AMMs use higher fees for more volatile assets to compensate LPs for the higher IL risk.
How do I check my impermanent loss?
Our simple google sheet, or if you want a better UX, tools like DailyDefi and WhiteboardCrypto.
So what should I do?
TL:DR; don’t passively LP assets indefinitely without thinking about it.
Like every investment strategy, providing liquidity has a specific payoff function. There is no free lunch, and in AMMs, if the relative price goes up or down a lot, we can lose money. If it stays roughly constant, we can make a lot of money. We just want DeFi retail users to understand that. There are several strategies to managing this risk including Uniswap V3, Perps, Option Vaults & our favorite, RMMs like Primitive.
Want to talk more about on-chain market making and derivatives? Please reach out!