Defi Basics - What is Impermanent loss?

29 days ago
(edited)
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If you start looking into Defi (decentralized finance) projects like WHive, there is a risk involved you may not be aware of called impermanent loss.

What is Impermanent loss?

When you provide liquidity to a swap you usually need to provide an equal valued token for each side of the swap. In the case of WHive - ETH or the upcoming WLeo - ETH, let's say you want to provide 1 ETH worth of liquidity. In the case of WHive pool, you would need to provide 2391.58 WHive to provide 1 ETH worth of liquidity.

If you would be allowed to only provide one side of the swap, the pool would quickly be unable to provide swaps as one token becomes more popular than the other.

Let's say we provide this 1 ETH worth of liquidity to the WHive-ETH pool, shortly later WHive goes up in price. At some point this price difference becomes an attractive opportunity to traders to take advantage of the arbitrage opportunity. Traders will then purchase WHive from the swap until the price is similar to exchanges.

At this point, people providing liquidity for this pool will be left with a combined value of assets that are worth less than if they just held those assets in their wallet.

For example, in our situation with WHive, we have the following tokens:

  • 1 ETH
  • 2391.58 WHive

WHive goes up 10%, and is now worth 1.1 ETH. Traders will buy WHive until the price on UniSwap reflects that ratio. In theory, if both assets were valued the same (like when you deposit into a liquidity pool), the final result would look something like 1.1 ETH & 2152.422 WHive. UniSwap has no way of knowing what the external price is of these assets and depends on traders to keep them in line. This does not happen immediately and is the result of profitable trades that cut into your profits as a liquidity provider.

If one asset in a swap varies dramatically, you can lose money providing liquidity. This is why stable coins are popular pairs on Uniswap as the risk of losing money due to pricing is minimized.

This is called impermanent loss as it is only a loss if you pull your tokens out of the liquidity pool. If the price comes back in line, the loss is mitigated. If you do pull your tokens out of the liquidity pool, the loss will become real. This loss is not always a loss to your investment, only compared to if you just held on to the coins in a private wallet rather than providing liquidity.

The more volatile the assets being swapped, the at risk you are for impermanent loss.

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