What is DeFi Impermanent Loss?

What is DeFi Impermanent Loss

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Impermanent loss (IL) is a phenomenon that can occur when trading on decentralized finance (DeFi) platforms that use automated market makers (AMMs). It occurs when the price of a token on the AMM deviates from the price of the same token on other markets, such as centralized exchanges.

In a practical example, Alice and Bob are liquidity providers (LPs) on an AMM for the token ABC. Alice provides 100 ABC and 100 ETH to AMM’s liquidity pool, while Bob provides 200 ABC and 200 ETH. The initial exchange rate for ABC to ETH on the AMM is 1:1.

If the price of ABC on other markets suddenly increases, more traders will want to buy ABC on the AMM, driving up the price of ABC in the liquidity pool. As a result, the exchange rate for ABC to ETH in the liquidity pool becomes 2:1. This means that Alice’s 100 ABC is now worth 200 ETH, and Bob’s 200 ABC is worth 400 ETH.

However, because the price of ABC in the liquidity pool is now different from that in other markets, Alice and Bob’s tokens may have different values outside of the liquidity pool. This means that if they decide to withdraw their tokens from the liquidity pool, they may experience a loss.

In this example, Alice’s loss is caused by the fact that when she deposited her tokens into the liquidity pool, the exchange rate was 1:1. Still, when she withdraws her tokens, the exchange rate is 2:1. Bob, on the other hand, does not experience any loss, as the increase in the price of ABC in the liquidity pool did not affect the value of his tokens.

Impermanent loss is not always a bad thing. However, it can be a trade-off for the potential gains from liquidity provisioning and trading on AMMs.

How to Avoid Impermanent Loss?

There are several ways to avoid or minimize impermanent loss when trading on decentralized finance (DeFi) platforms that use automated market makers (AMMs):

  1. Keep an eye on the market: Be aware of the prices of the tokens you’re providing liquidity for on other markets, and keep an eye out for any large fluctuations that could cause impermanent loss.
  2. Use stop-loss orders: Some DeFi platforms allow you to set stop-loss orders that will automatically close your position if the price of a token drops below a certain level.
  3. Use a diversified liquidity pool: Provide liquidity for multiple tokens in the same pool so that if the price of one token drops, the others can offset the loss.
  4. Use a risk management strategy: Use a strategy to manage your risk by adjusting your positions and allocating capital to different pools to mitigate the impact of impermanent loss.
  5. Be patient: Impermanent loss is a short-term phenomenon caused by temporary price fluctuations. As long as the pool’s liquidity is maintained, the price will adjust, and the loss will be recouped.
  6. Use a liquidity provisioning protocol that takes into account the impermanent loss, such as the Constant function market maker (cFMM)
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Remember that impermanent loss is not always avoidable and is a trade-off for the potential gains from liquidity provisioning and trading on AMMs. Therefore, it’s important to consider the risks and rewards when providing liquidity on a DeFi platform.

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