Because as long as the relative prices of tokens in the AMM return to their original state when you entered the AMM, the loss disappears and you earn 100% of the trading fees. Secondly, liquidity pools have a low market impact, as transactions tend to be smoother since they are based on an algorithm run by smart contracts. If you need to avoid permanent losses, staying away from volatile liquidity pools may be wise. A month later, ETH doubled in value while BTC’s price stayed the same.
A smaller range will result in greater liquidity concentration and higher rewards, but it also carries more risk. The invariant increases from each swap due to the protocol fee and NFT delta, so impermanent loss improves with more volume. Here is an example comparing IL from price changes if the LP was just added and after an additional volume equal to the pools TVL. 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.
How is impermanent loss calculated?
The simple way to mitigate impermanent loss is to provide liquidity for pairs where the relative price of each asset remains constant with the other in the pair. Therefore, liquidity providers are incentivized to participate in AMMs because they earn fees and yield in the form of newly-issued protocol tokens. She made some nice profits since her deposit of tokens worth 200 USD, right? But wait, what would have happened if she simply holds her 1 ETH and 100 DAI? When you provide liquidity to a pool, you deposit an equal value of each asset (e.g. $100 of ETH and $100 of DAI).
Here, X and Y are the reserve amount of each token in the pool, while K is a fixed constant that determines the pool size.
What Causes Impermanent Loss?
There will be no impermanent loss as long as prices do not move due to volatility. But as the price of the token rises, liquidity providers lose out compared to off-protocol token holders. In this very simplified example, you can see that IL happens whether prices go up or down.
LP’s are heavily incentivized to provide liquidity between the transaction fees and governance rewards, making it worthwhile for specific pairs. Those new to liquidity provision should stick with low volatile cryptocurrency pairings or stablecoin liquidity pools. Alternatively, investors can utilize some of the more complex liquidity pools to mitigate the https://www.xcritical.com/blog/what-is-liquidity-mining/ impact. For the more advanced cryptocurrency user, yield farming techniques can be implemented to ensure returns always stay far ahead of impermanent losses. There are also AMMs with a single asset type, where you can give a stablecoin to the pool to ensure its solvency. For example, KyberSwap Classic and Bancor are well known single-sided staking pools .
Bitcoin: The Game Has Changed
A year later, Uniswap emerged and managed to establish itself as the leading Ethereum-based AMM. Clearly this is an issue that needs to be addressed if AMMs are to achieve widespread adoption among everyday users and institutions. Whether products shown are available to you is subject to https://www.xcritical.com/ individual provider sole approval and discretion in accordance with the eligibility criteria and T&Cs on the provider website. Also, if ETH returns to the initial 100 USD value again, the loss will be reversed. The simple answer to this question would be— volatility in the crypto realm.
This causes many liquidity providers to look for token pairs that are likely to appreciate at a similar rate over time. Though, it is important to remember that your return is calculated after collecting fees. So even if unequal price fluctuations cause impermanent loss, you may still be able to make a profit if rewards from transaction fees cover the difference. Liquidity pools are smart contract enforced deposits of two tokens needed to enable swaps on a DEX. These pairs are usually set at a 50/50 ratio (but there are also uneven liquidity pools). For example, AMMs replace the order books of a centralised exchange with funds pooled by many users.