What is Impermanent Loss?
LPs suffer from impermanent loss when the price of the assets they have supplied to a pool decorrelate. The problem arises because of pool imbalancing due to arbitrage trading. As a consequence, LPs are worse off supplying liquidity to a pool relative to the HODL strategy.
The more the price of asset increases or decreases against another, the higher the loss will be as you will see in the table below. LPs are not the only victims of Impermanent Loss. Traders are affected too. As LPs suffer losses due to Impermanent Loss, AMMs increase trading fees in order to compensate them for their IL. This impacts traders.
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. You would have needed a 100% APY on your deposits just to be at par with a HODL strategy.
How does Impermanent Loss happen?
Impermanent loss happens for two reasons:
Protocol design: most AMMs use the constant product formula. This formula states that the product of asset quantities in the pool must always stay constant. If the price of one asset increases against the other asset, the pool needs to reduce its quantity. As a consequence, pools are always selling their best-performing asset, generating losses for their LPs.
No external market data: the only way to change prices in the pool is to change their quantities by buying and selling them. That’s the job of arbitrage traders. They make money off price differences between pools and centralized exchanges. Their activity extracts value from the pool’s LPs.
Consider the following table, which calculates IL for an ETH/DAI pool (50% ETH and 50% DAI) with an initial price of ETH set at 1000 DAI.
As you can see, the more the price of ETH deviates relative to DAI, the higher the impermanent loss. This phenomenon takes place both when the price of Ethereum goes up and down. Thus, IL amounts to 20% both when ETH goes down to 250 DAI and up to 4000 DAI.
You can calculate the IL for different asset prices using the Impermanent Loss Calculator.