IMPERMANENT LOSS

Impermanent loss is a concept that has become increasingly important in DeFi. In simple terms, it refers to the loss of value that can occur when trading on decentralized exchanges due to price fluctuations in the assets being traded. In this article, we will explore the underlying causes of , its potential impact on DeFi traders and investors, and ways to mitigate it.

The concept of Impermanent Loss arises from the fact that DEXs use liquidity pools, which are pools of assets that traders can use to buy and sell other assets. These pools are created by liquidity providers , who deposit assets into the pool in exchange for a share of the trading fees generated by the pool.?

The ratio of the assets that a liquidity provider deposits in a liquidity pool must be 1:1 of the dollar value for instance if a Liquidity provider wants to deposit 10ETH assuming that the price of ETH is $1000 then they must deposit a similar amount of say USDC. Therefore they will deposit $10,000 of USDC and 10ETH which is worth $10,000 and the total amount the liquidity provider will have deposited into the pool would be $20,000.

When a trader wants to buy or sell an asset, they can do so by interacting with the liquidity pool. The price of the asset is determined by the ratio of assets in the pool, and the trade is executed by adjusting this ratio.

When? the value of the assets in the pool changes due to market fluctuations, this leads to a loss of value for the Liquidity Providers. This is what is? known as Impermanent Loss.?

In our case, for example If the price of ETH? increases relative to USDC, the Liquidity Provider's position in the pool will decrease in value, even though the Liquidity Provider's assets have not been sold. This is because the Liquidity Provider's share of the pool is now worth less due to the change in the ratio of assets.

Now imagine if the price of ETH drops to $800 and a trader can buy the ETH from a centralized institution and sell it to the Liquidity pool for $1000.

The liquidity pool will continue buying Ethereum for $1000 until it stabilizes at $800.Using the Constant product AMM formula, the trader sell 2 ETH until the price stabilizes in the pool. The trader made a $400 profit.

Our liquidity pool now has 12ETH valued at $9600. The total value in the pool is $17600($9600 worth of ETH and $8000 of USDC). The total loss is 20,000 - 17,600 = $2,400.

The impermanent loss, which is the value of the tokens if they had not been invested into the liquidity pool would be: Amount of Tokens before Investing - Total Amount of Tokens in the LP

Amount of Tokens before Investing = $10,000 (USDC) and 10ETH valued at $8000 the total would be $18000.

Amount of Tokens in the liquidity Pool? = $17,600

Impermanent Loss = 18,000 - 17, 600 = $400

If both assets in a liquidity pool start moving in opposite directions, the liquidity provider starts to lose money very quickly. And if they increase at the same rate the liquidity provider will profit from the move. The graph below shows an estimation of the Impermanent loss in relation to the rate of change of assets in the liquidity pool.

The potential impact of Impermanent loss on DeFi traders and investors can be significant, particularly for those who are providing liquidity to multiple pools.?

Impermanent Loss is more pronounced during periods of high volatility, such as during market corrections or during the launch of a new asset. As a result, it is important for traders and investors to be aware of the potential for Impermanent loss and to take steps to mitigate it.

One way to mitigate Impermanent loss is to use smart contract-based liquidity protocols, such as Uniswap or Balancer, which automatically adjust the ratio of assets in the pool to minimize the impact of price fluctuations. These protocols use algorithmic trading strategies to ensure that the pool remains balanced, which can help to reduce the potential for IL.

Another approach is to use liquidity pools with low liquidity. These pools have a smaller trading volume, which means that they are less affected by market fluctuations. Additionally, using pools with low liquidity can also help to reduce the potential for slippage, which is the difference between the expected price of a trade and the actual price.

Diversification of assets in different liquidity pools also helps to mitigate the impact of impermanent loss. This will reduce the risk that a single asset will have a large impact on the overall value of the liquidity provider's position.

Conclusion.

Impermanent loss is called impermanent loss because the losses only becomes permanent loss once you withdraw your tokens from the liquidity pool.

It? is a complex issue that can have a significant impact on DeFi traders and investors. Impermanent loss happens no matter which direction the price changes. The only thing impermanent loss cares about is the price ratio relative to the time of deposit.

However, by understanding the underlying causes of Impermanent Loss and taking steps to mitigate it traders and investors can reduce their exposure to this risk. Additionally, traders and investors can also use automated market makers to automatically adjust the ratio of assets in the pools.?