All you need to know about Impermanent Loss.

Impermanent loss is one of the common terms used in Decentralized Finance and you will hear about it if you invest in crypto. But maybe you’re not sure what it is. Fine, some crypto terms can feel overwhelming and a little confusing. This article will focus on three things — what is impermanent loss, why it is called impermanent loss and how to improve it from a risk management point of view.

Let’s get started.

In DeFi, liquidity protocols enable everyone who has funds to become a?Market Maker (MM)?and get rewarded with trading fees. Anyone who provides her funds to the liquidity pool is called a liquidity provider. And as a liquidity provider, there are several things to note — impermanent loss tops the list.

So what is Impermanent Loss?

It is essential to understand the?liquidity pools and how they work?to understand the concept of impermanent loss. Be sure to read our article on liquidity pools and how they work here.

Impermanent loss is a ‘loss of value’ that occurs when the price of tokens changes compared to your initial deposit into the pool. This loss happens when the ratio of the tokens in the liquidity pool is different from the initial token ratio. Usually, liquidity providers do not know they are at a loss until they make a withdrawal or are ready to make one.

Pro tip:?Some liquidity pools are more exposed to impermanent loss than others. The rule is simple — the more volatile the assets are in the pool, the more likely you are to encounter impermanent loss. To get a rough estimate of what can happen in the pool, start by depositing small funds.

How does impermanent loss work?

To understand the impermanent loss, let’s consider the example below.

Suppose Dhure is to provide liquidity to the USDC-IVE pool on the Cardano blockchain. The tokens in the pool are USD Coin (USDC) and Surehive (IVE). He will have to provide an equal value of USDC and IVE. If the price of 1 IVE is equal to 10 USDC; and Dhure deposits $ 200 ($100 for each token), that would mean 10 IVE and 100 USDC of liquidity to the pool. Let’s suppose that the total liquidity pool contains 100 IVE and 1 000 USDC, that would mean Dhure owns 10% of the liquidity pool (100 000).

Pro tip:?The quantities of two tokens are bounded by a relationship called Automated Market Maker (AMM). In the case of a constant product AMM, the product of the quantity of the two tokens remains constant all the time, hence the liquidity pool is always even. Like in the case of our example 100 000.

In the process, the trader adds/removes base liquidity, and removes/adds quote liquidity; this influences the balances.

Due to the trading activities, the liquidity pool now has 50 IVE and 2000 USDC. So, Dhure decides to withdraw his funds. As we know from earlier, he’s entitled to a 10% share of the pool. As a result, he can withdraw 5 IVE and 200 USDC. If we assume that at the time of withdrawal, the value of 1 IVE is 25 USDC, Dhure is totalling 325 USDC. However, if we consider the value of the initial amount of tokens, Dhure would be worth 350 USDC. In this example, we can see that Dhure is at a loss of 25 USDC. However, the loss can be compensated with trading fees Dhure is entitled to receive based on his proportion in the liquidity pool.

Pro tip:?The liquidity provider gets a certain percentage of the pool’s transaction fees they provide with liquidity.

Whenever someone trades in that pool, the trader pays a fee of 0.3% of the quoted tokens — also known as trading fees (on some protocols, trading fees may be different) that are added to the liquidity pool.

Note: fees are split in proportion to the liquidity provider’s stake in the pool

A loss is only realized when the liquidity provider withdraws their liquidity and compares the difference in the asset price between the time of deposit and the time of withdrawal.

Pro tip:?Impermanent loss only becomes a permanent when you make a withdrawal. Consider it this way, you buy USD/ZAR at $16 yesterday, the trade is still open and it is now trading for $10. You are obviously at loss — but the trade is still open, so you expect things to change. If you close the trade at that point, the loss becomes permanent, but if you keep it open waiting for the tides to turn, it is impermanent

Conclusion: how to stay positive with Surehive

Impermanent loss can be counteracted with trading fees. The higher the trading volume in a pool, the higher its profitability, even if exposed to impermanent loss. This equation, however, depends on the protocol, the assets involved, and the market conditions.

This is where Surehive comes in.

SUREHIVE?will help you:

1. Surehive aims to make impermanent loss more transparent to the liquidity provider by providing on-chain real-time profit and loss analytics and portfolio updates through targeted email and social media notifications. Impermanent loss cannot be entirely avoided in AMMs but one thing is certain, it can be more transparent to liquidity providers. In most current AMMs, liquidity providers are not aware that their liquidity is at an impermanent loss until when they make a withdrawal.
2. Surehive aims to reduce impermanent loss by providing a High Capital Efficiency AMM protocol, allowing liquidity providers to provide liquidity around the area of high trading activities, hence receiving higher transaction fees.

Disclaimer: These articles are for informational purposes only and do not constitute any form of financial advice. All mentions of specific products/assets are only for informational purposes, and Surehive does not necessarily endorse the usage thereof (apart from where stated otherwise).

Also, it remains the responsibility of the reader to do their own due diligence before investing in DeFi products