Impermanent Loss

Liquidity Provider Risk

TL;DR

- Impermanent Loss can be thought of as the opportunity cost had you not participated in a Liquidity Pool.

- With a 50/50 token split Liquidity Pool, each side of the liquidity pool must maintain an equal value. To do so, the pool rebalances the amount of tokens you have on each side.

- Impermanent loss stems from a Liquidity Pool's requirement to maintain an equal amount of value on each side at all times. When an imbalance of value from rising/falling prices occurs, token quantities get readjusted.

- Impermanent loss is the trade-off of earning fees from a Liquidity Pool vs. not participating and realizing the full gains of the asset price rising.

Overview

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.

Example of 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.

First, we enter a 50/50 split XRP/USD Liquidity Pool, requiring us to have an equal amount of value on each side at all times.

The current price of XRP/USD is $100, so we decide to put up 1 XRP on one side and $100 USD on the other side. We now have a total value staked in the pool equalling $200 USD.

	XRP	USD
Price	$100	$1
Qty	1	100
Value	$100	$100
*Total Value*	$200

If the price of XRP skyrockets to $400 XRP/USD then the pool will have to rebalance. This takes place by arbitrage traders who will come in to buy up XRP with USD until the ratio reflects the current price. Don’t worry too much about this, it is just technically something we need to mention. The more important thing here is that the pool is out of balance because the price of XRP went up.

Let’s take a quick step back before our tokens are adjusted. On the XRP side of our pool we now have $400 USD worth of XRP, while we still have the original $100 USD on the USD side of things. This is not good, $400 does not equal $100.

	XRP	USD
Price	$400	$1
Qty	1	100
Value (not balanced)	$400	$100
*Total Value*	$500

Our new token amounts will need to be adjusted so that we have an equal value on each side, the rebalance results in a new amount of 0.5 XRP and $200 USD.

However we aren’t completely left in the dust with a rising price as our total value in the pool is up to $400 USD now. Originally we started at $200; not too shabby.

	XRP	USD
Price	$400	$1
Qty	0.5	200
Value	$200	$200
*Total Value*	$400

We can now see that the tokens we originally started with are drastically different. Originally we had 1 XRP, and now due to a rise in XRP’s price we only have 0.5 XRP. On the USD side of the pool, we doubled our holding of USD from $100 to $200. Again, each side must maintain an equal amount of value, not tokens, in a 50/50 split pool.

Ok almost done - Where the impermanent loss comes into play is when looking at what we WOULD HAVE made had we not participated in the pool and had our tokens subject to being rebalanced.

Had we not participated in the Liquidity Pool, we still would have had 1 XRP and $100 USD. With the rising of XRP’s price from $100 to $400, we would have had a total value of $500 USD ($400 * 1XRP + $100 USD). However, by participating in the Liquidity Pool we had only gained $400 USD, therefore our impermanent loss is $100 USD ($500 - $400).

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

Combatting Impermanent Loss

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.

Conclusion

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.