If you’re interested in contributing to a liquidity pool to claim a regular share of trading fees, which can be incredibly lucrative, one of the most important things you must be aware of is impermanent loss. It’s a complicated topic, but it’s one that is necessary to understand if you don’t want to incur unexpected and potentially significant losses.
In this AAG Academy guide, we’ll explain what impermanent loss is and what causes it, and look at some common examples in the cryptocurrency industry. We’ll also cover how you can calculate impermanent loss and minimize your exposure to it.
Lots of cryptocurrency investors rely on staking to maximize their returns on any coins or tokens they hold without actually trading them. It is an increasingly common practice — one that the cryptocurrency industry heavily relies on to continue functioning as intended. Without liquidity pool staking, the decentralized finance (DeFi) world as we know it simply wouldn’t exist.
Popular DeFi protocols like PancakeSwap, SushiSwap, and Uniswap depend on liquidity pools to perform the services they provide, and they allow almost anyone with the necessary funds to become a market maker and collect trading fees. This has paved the way for an automated, frictionless economy that has revolutionized cryptocurrency trading.
Before you start putting assets into a liquidity pool, however, it is important to understand the risks — one of the biggest of which is impermanent loss. Impermanent loss occurs when the value of the coins or tokens you have contributed to a liquidity pool changes compared to their value when you deposited them. The larger that change becomes, the bigger the loss.
What causes impermanent loss?
As we touched on above, impermanent loss is caused by a change in the value of assets while they are sitting in a liquidity pool. The easiest and most effective way to explain this is to provide an example, so let’s say that you choose to contribute to a liquidity pool that uses ETH and the DAI stablecoin as a token pair. You deposit 1 ETH and 100 DAI.
Since most liquidity pools require a 50/50 ratio of both tokens, we’ll assume that when these tokens were deposited, they were of equivalent value — or that 1 ETH was worth the same as 100 DAI. To keep things simple, we’ll say that the total value of this deposit is approximately $200, and that there is now a total of 10 ETH and 1,000 DAI in the pool. You have a 10% share of that, which is represented by 1 liquidity token.
Now, let’s say that a short time after your contribution to the pool is made, the price of a single ETH shoots up, and it’s now worth 400 DAI. While its price was climbing, arbitrage traders were taking advantage by adding DAI to the liquidity pool and withdrawing ETH in return. Eventually, the ratio between these two tokens starts to reflect current market values.
It’s important to note at this point that the price of assets in a liquidity pool is not determined by their values on external markets by default, but rather the ratio between them. In other words, a sharp rise in the price of ETH wouldn’t necessarily affect the pool right away. However, thanks in large part to arbitrage trading, the ratio eventually changes and starts to follow suit.
While the total value of the pool remains constant, there is no longer a 50/50 split between ETH and DAI. So, if a single ETH is now worth 400 DAI, we can assume the liquidity pool will eventually be made up of 2,000 DAI and only 5 ETH. Your liquidity token still entitles you to a 10% share of that, so let’s say you withdraw your assets and receive 0.5 ETH and 200 DAI.
Because the price of ETH has risen, the total value of your stake is now $400, and you have essentially doubled your money. That seems a worthwhile investment — until you consider that if you had just held onto the 1 ETH and 100 DAI you originally put into the liquidity pool, the total value of your assets would now be $500. The $100 (20%) difference is an impermanent loss.
Stablecoins vs. non-stablecoins in liquidy staking
It should be noted that when you contribute to a liquidity pool that uses a stablecoin in its token pair, your exposure to impermanent loss can be greater than if you contribute to a pool that uses two non-stablecoins. That’s because while the price of two non-stablecoins could rise alongside each other, the nature of stablecoins means that their value is always steady.
We can demonstrate this by repeating the example laid out above, but with different tokens. Let’s say, for instance, you contribute to a liquidity pool that uses ONE and AAG as the token pair. We’ll keep the figures the same for simplicity, so we’ll assume you deposit 1 ONE and 100 AAG, worth a total of $200, for a 10% stake. You get back 1 liquidity token in return.
Now, the ONE token sees a 4x rise in value because of a bull market, but as is often the case, the rest of the cryptocurrency industry is enjoying the same, and the price of AAG also rises by 2x. Even if it doesn’t rise as significantly, the fact that it rises at all reduces the difference in value between these two tokens on external markets.
As a result, the effects of arbitrage trading are reduced, and the ratio of ONE/AAG in the liquidity pool does not change as significantly. If you were to now take out your 10% stake, you would receive approximately 0.7071 ONE and 141.421 AAG, worth a total of about $565.69. Had you held onto those tokens, the new value would be $600, and the difference is just $34 (5.72%).
Of course, there’s no guarantee that both tokens will rise in value. There is also a possibility that while one token increases in price, the other decreases, in which case your potential impermanent loss will be even more significant than if you were invested in a liquidity pool that uses a stablecoin in its pair, like in the ETH/DAI example above.
Another thing to bear in mind is that both of the examples we’ve covered here leave out any trading fees you would earn for providing liquidity. These can vary depending on the pool you can contribute to, but they will reduce the amount of permanent loss you incur to some degree. Nevertheless, it’s still important to understand what impermanent loss is.
What makes impermanent loss ‘impermanent’?
You might be wondering why it’s called impermanent loss. The simple explanation for this is that when the token ratio in a liquidity pool changes, any losses you might incur at that point are not set in stone. If you were to leave your tokens in the liquidity pool and their values returned to the same levels they were at when you initially made your stake, there would be no loss at all.
How to calculate impermanent loss
The most accurate way to calculate impermanent loss is to use a free online calculator. There are lots to choose from, but we recommend the one provided by WhiteboardCrypto. It’s not only simple to use, but it has three different modes — simplest, simple, and advanced — that allow you to enter as much data as necessary to get an accurate result.
You can also estimate impermanent loss using the graph below.
This graph tells us that:
1.25x change in price results in a 0.6% loss
1.5x change in price results in a 2% loss
1.75x change in price results in a 3.8% loss
2x change in price results in a 5.7% loss
3x change in price results in a 13.4% loss
4x change in price results in a 20% loss
5x change in price results in a 25.5% loss
Again, please note that these figures do not take any trading fees earned into account. It’s also important to be aware of the fact that the loss is the same no matter which direction the price change occurs in. A 2x or 50% increase in the value of a token would have the same result as a 2x or 50% decrease. What’s more, the more you stake, the greater your loss could be.
How to avoid impermanent loss
The only truly effective way to avoid impermanent loss is to not participate in liquidity pool staking — or any other investment method in which impermanent loss can play a role. Once you have contributed to a pool, there’s nothing you can do as an investor to minimize the impact of token ratio changes in the liquidity pool. However, some moves can be safer than others.
As we touched on above, investing into a liquidity pool that uses stablecoins could lead to larger losses since the value of stablecoins remains, as the name suggests, stable. So, while one token’s value will change, there’s no opportunity for the other token’s value to follow suit. But it should be understood that this isn’t always the case.
It is possible for two non-stablecoins to move in opposite directions, thereby making your impermanent loss even greater. As a general rule, the more volatile the assets in the liquidity pool, the greater your exposure. The less you stake, the less you can lose.
Once your stake in a liquidity pool is withdrawn, losses are permanent. However, you may be able to reduce them by leaving those assets in the pool for longer if there’s a chance their values will return to the same levels they were at when you made your stake.
The only way to completely avoid impermanent loss is to not participate in any activity in which it is a risk — like liquidity pool staking. However, you can take some steps to reduce your exposure. These are outlined in the guide above.
A liquidity pool only runs out if all tokens are removed. In which case, your assets would be lost and any liquidity tokens you hold would be worthless. However, this is rare and usually only happens when scam projects or “rug pulls” are executed.
It can be a very big deal. Depending on how significant your stake in the liquidity pool is and the differences in token values when you withdraw it, losses can be vast. It is important to be aware of this before contributing.
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About the author
Senior content writer
Senior copywriter for AAG Marketing team with the focus of educating our community on all things web3, blockchain and Metaverse.
This article is intended to provide generalized information designed to educate a broad segment of the public; it does not give personalized investment, legal, or other business and professional advice. Before taking any action, you should always consult with your own financial, legal, tax, investment, or other professional for advice on matters that affect you and/or your business.