Welcome to whiteboard programming, where we
simplify programming with easy-to-understand whiteboard videos, and today, I'll be sharing
with you what is impermanent loss in crypto Well, impermanent losses are one of the risks
concerned with Liquidity Pools in DeFi. And to state its definition, it refers to the
difference in value between funds held in an AMM and funds held in your wallet. Impermanent
loss occurs when the value of the funds staked to the AMM fluctuates drastically. The
more significant the price fluctuations is, the greater the impermanent loss can be. Confused?
Let's understand this concept one step at a time with an example.
I'm assuming that you are aware
of a basic understanding of concepts like Defi and yield farming, if not, no worries, I've got
you covered with my these 2 videos, link for each can be found in the description below. So, yield
farming — also called liquidity mining — in DeFi has been at the heart of the market's explosion,
led by automated-market-making (or AMM) protocols. Some projects like Uniswap, SushiSwap, and
Balancer are known as decentralized exchanges, and they rely on such AMM protocols. Their
platforms allow traders to easily swap tokens in a completely decentralized and seamless manner.
This complete cycle is made possible by liquidity providers — i.e., users who deposit particular
crypto assets to the platform, thereby providing liquidity for other assets to be exchanged.
The Liquidity Providers are incentivized to deposit or lock-in, their assets because they earn
transaction fees generated by the traders swapping tokens on the given platform.
And if seen from
the perspective of Liquidity Providers — those locking their tokens into the DeFi protocol —
the transaction fees they earn are like a yield. And the value of this yield fluctuates, as it
depends on the protocol's usage and volume. With this being the foundational understanding, let's
dig deeper into How AMM liquidity pools work. In order for users of an AMM-powered protocol to
swap tokens, there need to be pools of liquidity available to them. For example, if a John wants to
sell 1 ETH for USDT… and, for simplicity's sake, if we say 1 ETH is trading for 1,000 USDT and
there's no platform fees, then there needs to be a liquidity pool that can take the 1 ETH
and give 1,000 USDT and vice versa. So, as trading volumes surge, so does the need for such
liquidity, and that is where those who are looking to be Liquidity Providers come in. These users can
deposit the two digital currencies of a pair — in this case, is ETH and USDT— to the protocol's
relevant pool(s) in a predetermined ratio, which, in the most cases is 50/50.
Now, to understand
things better let's take another example, if a Liquidity Provider with 10 ETH wishes to add
liquidity to an ETH/USDT pool with a 50/50 ratio, they will need to deposit 10 ETH and 10,000
USDT (by still assuming 1 ETH = 1,000 USDT). If the pool they commit to has a total of 100,000
USDT worth of assets (50 ETH and 50,000 USDT), their share will be equal to
20% by this simple equation… Also, the percentage of the Liquidity Providers
share in a given pool is important to note because when the Liquidity Provider commits or deposits
their assets to the pool via a smart contract, they will automatically be issued Liquidity
These tokens entitle the Liquidity Provider to withdraw their share of
the pool at any time which is 20% of the pool in our stated example. Now, this is where the
concept of impermanent loss comes into play. Since Liquidity Providers are entitled to their
share of the pool and not a specific number of tokens, they are exposed to another layer of
risk — which we call impermanent loss and it happens when the price of your deposited assets
changes compared to when you deposited them. Remember here, the bigger this change is, the more
you are exposed to impermanent loss and in this case, the loss means less dollar value at the time
of withdrawal than at the time of deposit.
Also, do note that it is called as “impermanent”
because as long as the cryptos can return to the price when they were deposited on the
AMM, no loss occurs, and the Liquidity Provider also gets 100% of the trading fees. Next, let's
understand how to calculate impermanent loss, so, in our example, the price of 1 ETH was 1,000
USDT at the time, but let's say the price doubles and 1 ETH starts trading for 2,000 USDT.
the pool is adjusted by an algorithm, it uses a formula to manage assets. The most basic and
widely used one is the constant product formula, which is popularized by Uniswap. In simple
terms, the formula states: ETH liquidity x token liquidity = constant product Using figures from
our example (based on 50 ETH and 50,000 USDT), we get: 50 x 50,000 = 2,500,000 Similarly, the
price of ETH in the pool can be obtained with this formula: token liquidity / ETH liquidity =
ETH price And on applying our example figures, we get: 50,000 / 50 = 1,000 USDT (i.e., the
price of 1 ETH). Now, when the price of ETH changes to 2,000 USDT, we can use these formulas
to ascertain the ratio of ETH and USDT held in the pool with these equations further, on applying
data from our example here along with the new price of 2,000 USDT per ETH gets us the following
so, we can confirm the accuracy of this by using the very first equation (ETH liquidity x token
liquidity = constant product) to arrive at the same constant product of 2,500,000, which can be
seen as follows: 35.355 x 70,710.6 = ~2,500,000 (which proves as the same as our original constant
Hence, after the price change, assuming all other factors remain constant, the pool will
have roughly 35 ETH and 70,710 USDT, compared to the original 50 ETH and 50,000 USDT. If at this
time, the Liquidity Provider wishes to withdraw their assets from the pool, they will exchange
their Liquidity Provider tokens for the 20% share they own. Taking their share from the
updated amounts of each asset in the pool, they will get 7 ETH (i.e., 20% of 35 ETH)
and 14,142 USDT (i.e., 20% of 70,710 USDT). Now, the total value of the assets withdrawn
equals: (7 ETH x 2,000 USDT) + 14,142 USDT = 28,142 USDT.
However, if the user
simply held their 10 ETH and 10,000 USDT, instead of depositing these assets into a DeFi
protocol, they actually would have gained more… Assuming ETH doubled in price from 1,000 USDT to
2,000 USDT, the user's non-deposited assets would have been valued at 30,000 USDT, simply as (10 ETH
x 2,000 USDT) + 10,000 USDT = 30,000 USDT. That difference of 1,858 USDT— which can occur because
of the way AMM platforms manage asset ratios is what is known as impermanent loss. So,
now that, we know what is impermanent loss and how to calculate it, let's talk about
how you can avoid impermanent loss… Well, although, there is no way to avoid impermanent
loss, Liquidity Providers can still take a few measures to mitigate the risk. 1. Use Stablecoin
Pairs: Now, by providing liquidity in stablecoin pairs is the best bet against impermanent loss.
Since stable coins value doesn’t fluctuate much, they present low arbitrage opportunities, thus
decreasing the risks.
However, at the same time, Liquidity providers who hold stablecoins
cannot enjoy the rise in the crypto market. 2. Avoid Volatile Pairs: Instead of choosing
cryptos with an unstable or volatile history, pick up pairs that don’t expose liquidity to
impermanent loss. 3. Thoroughly Search The Market: Crypto markets are highly volatile. Hence, it
is normal that deposited assets move up or down in value. However, Liquidity providers must
know when to pull out their cryptocurrencies before the price deviates too far away from
the initial rate. Lastly, as a conclusion, I'd like to say that impermanent loss is the sole
reason why big financial institutions don’t enter the liquidity pools. This issue should be solved
if AMMs are to achieve widespread adoption among businesses and individuals worldwide. And though,
various forks of Uniswap have come up in recent months that try to solve the issue, we are yet to
see a clear winner who can help avoid this loss of liquidity.
With that, I hope this video was
helpful to you and served, if you love my content, feel free to smash that like button, and if
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