Impermanent Loss

Understanding Impermanent Loss

Impermanent loss refers to the difference in potential gains from holding tokens in an Automated Market Maker (AMM) versus simply holding them in your personal wallet. This type of loss occurs when the price of tokens in a liquidity pool shifts from the price at the time they were initially deposited. If the prices return to their original levels, the loss is considered temporary, as the value reverts to its initial state. However, if the prices stay altered, the loss becomes permanent.

While trading fees earned from liquidity provision can help offset such losses, it’s essential to have a solid understanding of the dynamics behind impermanent loss.

For a comprehensive understanding of IL, this nifty article can provide additional insight.

How to Minimize Impermanent Loss?

Impermanent loss arises when there is a significant price divergence between the assets in a liquidity pool. To mitigate this, it’s important to consider the historical price behavior and volatility of the assets before committing liquidity. For assets with high price fluctuations, it may be beneficial to opt for a broader price range, reducing the likelihood of impermanent loss. Using correlation analysis can help assess the relationship between the assets you're supplying liquidity to:

• High correlation between assets can potentially lower the risk of impermanent loss.

• Low correlation increases the likelihood of impermanent loss.

The size of the liquidity pool and its trading volume can also influence the risk. In general, larger pools with higher trading volumes tend to reduce the risk of impermanent loss. Since impermanent loss is an ongoing risk, it’s vital to regularly monitor your liquidity positions and adjust your strategy as needed. This might include rebalancing your liquidity, modifying your price ranges, or withdrawing your liquidity altogether.

Impermanent Loss in V3

The concentrated liquidity model in V3 allows liquidity providers (LPs) to place liquidity at specific price levels. However, this can expose LPs to greater risk from price volatility compared to V2. If the price of assets moves outside the specified price range where liquidity is concentrated, LPs may experience larger losses. Impermanent loss occurs when the price of deposited assets changes from their initial deposit price. If the price returns to its original level, the impermanent loss is nullified. However, if you withdraw your liquidity before the price returns to the initial level, the loss becomes permanent.

Example A: Narrow Range Spike provides liquidity to a token pair (ETH/USDC) within a range of $1000-$1500.

• As long as the price stays within this range, Spike earns fees from trades.

• If the price moves outside this range, Spike faces the risk of greater losses.

Example B: Wide Range Timmy offers liquidity to the same token pair with a range of $500-$2500.

• Though Timmy's range is broader, allowing him to earn fees from a wider price movement, his capital is less efficiently utilized.

• If the price stays within the range of $500-$2500, Timmy has a smaller chance of facing impermanent loss compared to Spike, but his liquidity is working less efficiently.

Example C: Out of Range (Manual Mode) Jim provides liquidity to a token pair with a range of $800-1200 (ETH/USDC)

• If the price rises to $1200, Jim holds only USDC.

• Should the price drop to $1000, Jim would experience impermanent loss since he had less exposure to ETH when the price was within his range.

Simply put, impermanent loss in V3 depends on your chosen price range and the price changes of the assets. By selecting a wider range, you reduce the risk of impermanent loss, but may also earn fewer fees.

Does Single-Sided Liquidity Provision in V3 Eliminate Impermanent Loss?

Single-sided liquidity provision in V3 helps reduce the impact of impermanent loss, but it doesn’t entirely eliminate the risks. Providing liquidity still carries risks, including price fluctuations and market volatility.