What is Impermanent Loss?
LPs suffer from impermanent loss when the assets they have been supplying liquidity to decorrelate.
Essentially, this means that the more an asset increases against another, the higher the loss will be. For instance, if an asset doubles in price, the loss will be around 10%. Beware, LPs also suffer from impermanent loss when prices drop!
Why should I care?
LPs are losing billions of dollars each year due to impermanent loss. If you had invested in a tripool BTC-ETH-DAI in 2015, you would have lost 90% of your capital compared to a HODL strategy. This would have required you to get 100% APY from trading fees to just be at par with a HODL strategy.
You can check how much you lost due to IL at: https://il.wtf/
How does Impermanent Loss actually happen?
Impermanent loss happen due to two factors:
- Protocol design: most AMMs follow the constant product formula. It means that a pool of liquidity needs to have both sides of the pool balanced in value. So, if the price of one asset increases against the other asset, you need to reduce its quantity. Consequently, you are always selling the asset that performs best.
- No external market data: arbitrage traders can capture value by trading assets on both DeX and CeX.
See the following example:
- There are 100 Bitcoin and 100 DAI in a liquidity pool. Since the pools need to be balanced in terms of value, the price of a Bitcoin is 1 DAI.
- On the other hand, the price of the Bitcoin surges on Centralized Exchanges to 2 DAI
- Arbitrageurs notice the imbalance between the DeX price and the CeX price.
- They start buying 1 BTC at 1 DAI on the DeX and selling it at 2 DAI on the CeX
- Consequently, the pool has 99 BTC and 101 DAI, which means the price of 1 BTC rises to 1.02 DAI
- Arbitrageurs continue to trade until the price on the DeX reaches the price on the CeX
- There remains 70 BTC and 140 DAI in the pool, after all the trades
- Consequently, the total value in the pool is: 70 BTC + 140 DAI = 280 DAI
- If someone had HODLed the same position before the price surge, the total value would have been: 100 BTC + 100 DAI = 300 DAI
- Impermanent loss amounts to 20 DAI, ~10% of the initial position