What is Impermanent Loss?
Once you’re red-pilled and tip your toes into DeFi, you’ll hear the term “impermanent loss” pretty quickly. It’s one of the most important concepts when you start with yield farming.
Impermanent loss occurs when the price of the tokens you deposited changes compared to the price of the tokens at the time of depositing. The bigger the change, the bigger the impermanent loss.
This may sound weird because it looks like you can lose money when you’re yield farming. Aren’t you suppose to earn a profit? Well, yes, it’s possible to lose money, and I am going to explain how it can happen. And why Clip Finance isn’t exposed to such risk.
What Is Impermanent Loss?
Let’s go through an example and use Uniswap liquidity pool as our base case. When you provide liquidity to an AMM (Automated Market Maker, i.e. decentralized exchange like Uniswap) liquidity pool, you’re depositing a token pair (two different tokens).
Now, if the price of the deposited assets changes, the impermanent loss occurs in dollar value at the time of the withdrawal.
Let’s say you deposit 100 USDC and $100 worth of SOL tokens. For the sake of the example, let’s say that it’s 1 SOL ($100–1 SOL) at the time of depositing. With this made-up liquidity pool, both tokens always need to be in equal value at the time of depositing (it’s a standard that both tokens have to be in equal dollar value). Your total deposit value is $200.
Additionally, other people have deposited to the same pool as well, and there’s 1000 USDC and 10 SOL total in the pool. As a result, your share of the pool is 10% (out of total liquidity of $2000).
Because Automated Market Makers do not have order books, the price is determined by the token ratio in the pool. Now if the price of SOL increases from $100 to $400, traders will add more USDC to the pool and remove SOL from the pool, so the pool would end up in 50–50 value for both tokens in dollar terms.
As a result, instead of 10 SOL in the pool, we have 5 SOL in the pool and 2000 USDC thanks to the arbitrage traders. Instead of $200 deposited, you now have $400, as your share represents 10% of the pool (value of the pool has grown to $4000).
You’ll withdraw the funds and end up getting 0.5 SOL and 200 USDC (total $400 as the SOL price is now $400).
However, if you hadn’t provided liquidity and instead just held on to your SOL, you would have 1 SOL ($400) and 100 USDC, with a total value of $500. Hence, by providing liquidity you actually lost $100 compared to just holding the assets. And this is called impermanent loss.
It’s called impermanent loss because the loss is only on paper. If you don’t withdraw your funds, and the price of SOL goes back to $100, you won’t have any impermanent loss. If you do withdraw your liquidity, then you will realise your loss.
Here’s a sample calculation of impermanent loss from Binance Academy. As you can see, the more price changes, the bigger are your losses.
- 1.25x price change = 0.6% loss
- 1.50x price change = 2.0% loss
- 1.75x price change = 3.8% loss
- 2x price change = 5.7% loss
- 3x price change = 13.4% loss
- 4x price change = 20.0% loss
- 5x price change = 25.5% loss
The given example doesn’t take into account the trading fees that you can earn by providing liquidity, and this can cover the impermanent loss and more. That being said, it’s wise to be aware of the impermanent loss and how it occurs, and how to protect yourself.
How To Protect Yourself Against Impermanent Loss?
Pools that include tokens with low price volatility have less risk of impermanent loss. The least volatile tokens are stablecoins. At Clip Finance we’re only farming yield from stablecoin pools, i.e. our users are not exposed to impermanent loss.
Considering the volatile market of crypto where the bear market can mean a 90% drop in asset prices after the previous 90% drop, having exposure to stablecoins is extremely important to preserving wealth.
Farming stablecoins probably has the best risk-return ratio in any financial market currently. Considering the geopolitical uncertainty and inflation, the difficulty of positioning yourself financially is apparent.