If you have heard about Liquidity Pools prior to reading this article, then you may have heard about Impermanent Loss. If you are unfamiliar with Liquidity Pools, check out our article. Impermanent Loss is a risk when participating in a Liquidity Pool. It can be thought of as the opportunity cost from the gains you would have realized from rising token price had you not participated in a Liquidity Pool. This is because in Liquidity Pools, your token quantities that you originally stake will vary over time to maintain an equal value on each side of the pool. Price fluctuation in each asset can cause an imbalance in value, and therefore your token quantities will adjust up or down. If a rising price rebalances a token by decreasing its amount, you will have lost out on the gains you would have had by not participating in the pool and maintaining your original token amount. Still not clicking right? Do not be discouraged, it is not the most intuitive topic.
At its core, the opportunity cost is due to the fact that you must maintain equal amounts of value in a Liquidity Pool and not an equal amount of tokens in the liquidity pool. At any given time, the total value you stake on each side of the pool must remain the same. If I am participating in a XRP/USD Liquidity Pool, then I have to stake $50 USD on one side of the Liquidity Pool and $50 USD worth of XRP on the other side. When the price of either asset goes up or down, each side must rebalance by a formula (we won’t go over in this article) that changes the amount of tokens you have on each side of the pool in order to maintain an equal value.
If the price of XRP goes up after we enter a Liquidity Pool, then the amount of XRP tokens that we had originally staked will have to go down to rebalance the pool. Had we not participated in the Liquidity Pool, then we would have had the same quantity of XRP and would have profited from the rise in its price. This is fundamental to understanding Impermanent Loss.
Ok so let’s look at an example of impermanent loss and what happens when the price of two assets change over
time, step by step. In this example we will look at a XRP/USD Liquidity Pool that is 50/50 split, meaning we
have to have an equal amount of value on each side of the pool at all times, not an equal amount of tokens. We
will see what happens when the price of XRP rises relative to the price of USD. Let’s make one assumption real
quick and be super bullish and say that the current price of XRP is $100 XRP/USD. I doubt many people reading
this would complain about that, so we’ll run with it.
A quick recap shows:
- Initial total value when we first entered the pool: $200
- End value due to rising XRP price in Liquidity Pool: $400
- Our total value had we just held and not participated: $500
- Impermanent loss: $100
It is VERY IMPORTANT to note that impermanent loss only occurs when you take your funds out of the Liquidity Pool. It can be thought of as a temporary loss only realized when you exit the pool.
Let’s say the above scenario happened where XRP skyrocketed up to $400 XRP/USD from $100 XRP/USD (where it was we entered the pool), but you decided to stay put in the pool and wait things out. If the price of XRP goes back down to $100 XRP/USD your tokens would then rebalance to where they were originally at when you first started. You may be asking yourself, "Then why even participate in the pool? Where do I make money from risking my tokens being rebalanced in a pool?". Well what we avoided showing in the example was the fees that you accrue by participating in the pool.
As we covered in our Liquidity Pool article, you earn rewards from a Liquidity Pool by gaining a portion of the transaction fees that traders have to pay when exchanging tokens. Depending on how long you stay in the pool to earn these fees, and how much the price moves against you, the fees can offset any impermanent loss that you realize. This MUST be taken into account in your strategy when participating in a Liquidity Pool.
A couple other notes to keep in the back of your head is that a potentially profitable strategy for participating in a Liquidity Pool is to find a time in the market when the prices of the assets you are staking are trading “sideways”, or not experiencing drastic fluctuations in price. This means that your impermanent loss would be mitigated because your tokens wouldn’t have to rebalance as drastically, and any fees that you earn would offset any impermanent loss you might incur.
Another might be that you are bullish long term on a particular token that you are staking, say XRP. And that the XRP/USD price, you feel, might be overbought and is due for a correction in price, potentially back to its mean price. To accumulate more XRP you can enter a XRP/USD liquidity pool at the height of the XRP/USD price and hope that the price decreases. Token rebalancing in a Liquidity Pool goes both ways - If XRP’s price rises the tokens on the XRP side decrease. But if XRP’s price falls, the amount of XRP tokens will increase. Because you are long-term bullish on XRP, you don’t care for short-term price dips, you just care about accumulating more. Food for thought.
We hope that helped understand what Impermanent Loss is. Rereading this and other articles about permanent loss will help you further grasp the concept.
Now to bring it full circle - Again, the trade off for participating in a Liquidity Pool is the rewards earned for providing liquidity in the pool vs. the potential gains you would have received from a rising price had you not staked your tokens. When you analyze your profit and loss from a liquidity pool, you need to look at your impermanent loss, while also factoring in the fees you gained as well. Staying in a Liquidity Pool for a long period of time can earn you a lot in fees.