In the world of DeFi (decentralized finance), impermanent loss is a concept that is often mentioned but not easy to understand. When you deposit assets into a liquidity pool as a Liquidity Provider (LP), if the price of the assets in the pool changes compared to when you deposited it, you may suffer losses. This loss is called an impermanent loss because it may disappear when the asset price recovers, but if the price does not recover, the loss becomes permanent.
How do impermanent losses arise? Learn more about how AMM works
The root cause of impermanent losses lies in the operating mechanism of the Automated Market Maker (AMM). AMM is a smart contract used in DeFi protocols to facilitate the exchange of assets, and it operates completely differently from the order book system in traditional finance. In AMM, assets are deposited into a pool by liquidity providers. These assets can be any two tokens (such as TON and USDT).
When liquidity providers provide liquidity, they usually deposit two assets of equal value. When the price of an asset in the pool changes relative to when it was originally deposited, AMM will adjust the quantities of the two assets based on a pre-set mathematical formula (such as Uniswap’s constant product formula) to maintain a balance in the asset pool. Such an adjustment would cause the value of the currently held tokens to decrease relative to the value of the direct holdings, thereby creating an impermanent loss.
Impermanent losses are called “impermanent” because in theory such losses can be temporary. If the market price returns to the same position it was at when you provided liquidity, the losses will disappear. However, in the real world, price changes often do not return to the original point according to the ideal trajectory, so impermanent losses may become permanent losses.
The operating principle behind impermanent loss: a comprehensive analysis of the AMM system
To understand the nature of impermanent loss, we first need to have a deeper understanding of automated market makers (AMMs). AMM is an algorithm-based system for trading on decentralized exchanges (DEX). Unlike traditional exchanges, AMM does not have order books for buyers and sellers, but is funded by a Liquidity Pool, which comes from user deposits.
In the AMM model, the price of a transaction is determined by the proportion of assets in the asset pool. For example, on Uniswap, the constant product formula $x \times y = k$ is used to ensure equilibrium between assets in the pool. This means that when someone buys an asset, the amount of that asset in the pool decreases and the price increases.
When the price changes, the proportion of assets in the liquidity pool changes accordingly. For example, if you provide liquidity to the TON/USDT pool, when the price of TON rises, AMM will increase the USDT in the pool and decrease TON to maintain the equilibrium of $x \times y = k$. In this case, the value of your asset portfolio may become less than the value of directly holding TON and USDT, which is an impermanent loss.
The Math of Impermanent Loss: Understanding the Calculations Behind Risk
The calculation of impermanent loss involves some math, but understanding the mechanics behind it is critical for liquidity providers. The extent of impermanent losses depends on the extent of the asset’s price movements. Specifically, the impact of impermanent losses increases when the price ratio of two assets changes significantly.
Impermanence loss can be approximately calculated using the following formula:
For example, let’s say you provide liquidity in a TON/USDT pool and the initial price of TON is 1 USDT. As the market fluctuates, the price of TON rises to 2 USDT, so the price change ratio is 2.
Substitute into the formula to calculate:
This means that you will lose approximately 5.87% of the value of your assets compared to holding them directly.
How to reduce the risk of impermanent losses? Four key strategies to help you avoid risks effectively
Impermanent losses are one of the important risks that every liquidity provider must consider. Although impermanent loss cannot be completely eliminated, there are some strategies that can effectively reduce its impact:
1. Stablecoin trading pairs: the first choice to reduce volatility risk
Liquidity providers can choose trading pairs between stablecoins to provide liquidity, such as USDT/USDC or DAI/USDC. Since the price fluctuations of stablecoins are less, the risk of impermanent losses is also relatively low. This strategy is suitable for investors with lower risk tolerance.
2. Join the impermanent loss insurance pool: double protection of your capital security
Some DeFi platforms provide impermanent loss insurance for liquidity providers, so that when asset prices fluctuate excessively, losses can be reduced through insurance compensation. This type of insurance can effectively reduce the impact of unpredictable losses on funds.
3. Monitor market dynamics: Seize the best exit opportunity
Pay close attention to market trends and consider temporarily withdrawing from the liquidity pool when asset prices are expected to fluctuate significantly. Such an operation can lock in profits in advance and reduce the risk of losses before the market fluctuates too much.
4. Choose a high-yield liquidity pool: Use profits to offset losses
Some liquidity pools provide higher transaction fees or mining rewards, and these earnings can compensate for impermanent losses to a certain extent. Therefore, choosing a high-yield pool can help offset possible impermanent losses.
TON/USDT Liquidity Pool Example Analysis: Impact of Impermanent Loss under Three Market Scenarios
Assume that you provide liquidity in the TON/USDT liquidity pool and the initial price of TON is 1 USDT. As the market fluctuates, the price of TON may change in the following three situations:
Scenario 1: TON price rises to 1.5 USDT
If the price of TON rises from 1 USDT to 1.5 USDT, then the amount of TON in the liquidity pool will decrease, while the amount of USDT will increase. According to the formula of impermanent loss, the impermanent loss at this time is approximately 2.02%. Although the losses may seem small, they can increase if the price moves by a larger amount.
Scenario 2: TON price drops to 0.5 USDT
If the price of TON drops to 0.5 USDT, then the amount of TON in the pool will increase and the amount of USDT will decrease. The impermanent loss at this time is approximately 5.72%. It can be seen that when prices fluctuate significantly, the impact of impermanent losses becomes more obvious.
Scenario 3: TON price returns to 1 USDT
If the price of TON eventually returns to 1 USDT, the proportion of assets in the liquidity pool will also return to its original state, the impermanent losses will disappear, and the value of the assets you ultimately hold will be the same as when you initially deposited it.
More than just impermanent losses: Other risks liquidity providers need to be wary of
In addition to impermanent losses, liquidity providers also need to consider other risks when participating in DeFi protocols:
1. Smart contract vulnerabilities: code security is crucial
DeFi protocols are based on smart contracts, and the code of smart contracts may have vulnerabilities or be exploited by malicious attackers. Therefore, investors need to choose protocols that have undergone security audits and carefully evaluate their security.
2. Asset liquidation risk: consequences of insufficient collateral
In some DeFi lending protocols, if the value of a user’s collateral assets falls to a certain threshold, it may be liquidated. This means that users’ assets will be forced to be sold to repay the borrowed money, resulting in potential losses.
3. Systemic risk: knock-on effects of the DeFi ecosystem
Due to the complex interdependencies between DeFi protocols, problems with one protocol may trigger a chain reaction, causing the operation of other protocols to be affected. Therefore, liquidity providers should diversify their investments to reduce the impact of systemic risks on funds.
Becoming a Successful Liquidity Provider: Key Skills and Advice
To become a successful liquidity provider in the DeFi world, in addition to understanding impermanent loss, you also need to master a variety of knowledge and skills:
- Risk management: Clarify your own risk tolerance, choose an appropriate liquidity pool, and adjust investment strategies in a timely manner based on market dynamics.
- Familiar with DeFi platform operations: Understand the operating procedures and rules of major DeFi platforms, especially the return and risk characteristics of various liquidity pools.
- Participate in community communication and learning: Actively participate in discussions and exchanges in the DeFi community, obtain the latest market information and investment advice, and make more informed decisions.
Mastering Impermanent Loss: Final Tips for Protecting Assets in DeFi
Impermanent losses are an important risk that DeFi investors need to pay close attention to. Although it cannot be completely avoided, its impact can be effectively reduced through strategies such as choosing stablecoin pairs, monitoring market dynamics, selecting high-yield liquidity pools, and participating in impermanent loss insurance. In addition, understanding the operating mechanism of AMM, mastering relevant mathematical calculations, and doing risk management will help you better protect your assets and achieve stable returns in the DeFi world.
In this rapidly developing field of decentralized finance, only through continuous learning and prudent risk management can one become a successful liquidity provider and seize the huge opportunities provided by DeFi.
Ultimately, the DeFi world is full of opportunities and challenges. Impermanent loss is just the tip of the iceberg, and as you further explore the DeFi field, you will discover more details and potential risks. The key to success lies in continuous learning and flexible coping strategies. Every time before participating in liquidity mining or any DeFi project, please take the time to study the relevant protocols and understand their mechanisms and risks. Remember, good risk management and a diversified investment strategy can help you stay calm in the face of market fluctuations and ultimately achieve the desired returns.
As you master these skills and learn from other community members, you will be better equipped to respond to future market changes. Hopefully this article will help you gain a deeper understanding of the concept of impermanent loss and make more informed decisions in the DeFi world. I wish you great results in your DeFi investment and achieve your financial goals!
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About LayerPixel：
LayerPixel is an all-in-one DeFi protocol designed specifically for the TON blockchain and seamlessly integrated with Telegram Mini Apps. Leveraging a modular architecture, LayerPixel overcomes the asynchronous limitations of TON while harnessing its sharding benefits.
At the core of the LayerPixel ecosystem are several innovative components:
- PixelWallet - An SMC wallet with Account Abstraction (AA) features, enabling users to interact with dApps and the LayerPixel ecosystem with ease.
- PixelSwap - The first modular DEX on TON, supporting advanced trading models like weighted pools and LBP.
- Pixacle - A decentralized oracle solution delivering fast and accurate price data to dApps and smart contracts.
LayerPixel’s future plans include becoming a cross-chain solution to power DeFi experiences across all Telegram Mini Apps. By providing an all-in-one platform, LayerPixel aims to make blockchain-powered finance accessible to everyone within the TON ecosystem.
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