What does impermanent loss in DeFi refer to? It’s a very real risk. How can you avoid losing money because of it?
Let’s begin with an analogy. I was a pro wrestler years before I began my crypto career. For real.
The Ladykiller, fighting out of Singapore. Exactly what this website domain represents.
One of the most memorable matches I’ve ever had was a championship bout in Malaysia Pro Wrestling in 2016. It was a 1 vs 1 vs 1 contest, and the use of weapons was allowed. Encouraged even. In wrestling we call that a triple threat hardcore match.
During this fight, I seized the early advantage and dominated. I was on fire. And boy was the crowd loving it.
But one of my opponents found an opening, and swung a metal trash can at me to regain momentum. The sharp edge of the bin caught me in the forehead like a cookie cutter stamping through dough, and I dropped to the mat.
I could feel fluid trickle down my eyebrow. At first I thought it was just profuse perspiration. But as I staggered to my feet I saw bright red droplets hitting the canvas. They had fallen from my face. I was bleeding.
The crowd was going nuts that I had been busted open. It was exciting. It’s what makes hardcore matches, hardcore.
Now let’s get back to crypto. We’ll finish the story later.
Let’s say you wanna participate in the area of DeFi called automated market making (AMM). But you also want to avoid bleeding and losing your crypto. What strategies can you employ?
First, impermanent loss is what happens when you provide liquidity to a market making pool, and the asset values diverge.
Trace the story above and you should be able to note the following elements:
Keeping up? Great.
Let’s use the example of Uniswap. When you deposit crypto to Uniswap as a liquidity provider, you put up 2 assets in a 50:50 ratio by dollar value. Let’s call these assets A and B.
If the price of asset A started to appreciate in the outside world, arbitrageurs will descend rapidly on Uniswap to buy A because it’s still cheap (removing it from the pool), paying the other asset B (adding that to the pool). This adjusts the prices of A and B relative to each other.
If you looked at the pool, you’d realise you’ve bled out on a few tokens of the outperforming A, and would now have got more of the underperforming B. Arbitrageurs have taken away some of your A and replaced it with B.
Impermanent loss is when you begin to bleed out on one of your tokens after it rallies.
This is what we refer to as impermanent loss. Arbitrageurs have walked away with profits at the expense of the liquidity pool. That’s the loss. It’s called impermanent because suppose B were to start gaining instead, you’d then recoup the loss in quantity of A, while seeing your excess B decrease, leaving you not worse off after all.
Let’s use SNX as a case study. Say liquidity providers deposited SNX and ETH into a pool on Uniswap a year ago.
They would have missed out on profiting from SNX’s insane 2020 rally because they were bleeding out on SNX tokens on Uniswap, receiving the less valuable ETH that comprised the other half of their pool.
Those poor guys would have been in a better situation if they had just stayed outright long on SNX alone, instead of leaving it in a market making liquidity pool, and losing those precious assets to arbitrageurs.
Let’s look at this graph. Red = trading fees; Blue = impermanent loss; Yellow = net profit
Impermanent loss is extremely damaging to your portfolio value when one asset goes on a tear and leaves the other in the dust. You’d find yourself left with only a fraction of the more valuable asset.
Your compensation for being a market maker is trading fees. You collect about 0.3% fee revenue per trade. Let’s talk about some setups that would minimise your impermanent loss, while helping you earn trading fees, so that you’re firmly net positive.
The basic idea is that the ratio of those assets should preferably remain steady, so by selecting the following types of pools you’ll keep impermanent loss at bay. You do not want to participate in a pool where one asset will have a higher growth rate than the other. Generally, avoid providing liquidity to an AMM pool if you’re not equally bullish on both components, unless the compensation makes up for it.
Such as renBTC and WBTC (both pegged to BTC value), or sETH and WETH (both reflect ETH value). Impermanent loss is minimised here because obviously they trade in a highly correlated manner. Theoretically their value is designed to be 1:1.
So, you make money from randoms in the market just swapping one for the other all day long, paying you fees, on a pair of assets with predictably low divergence risk. Your fee income will grow reliably with time.
I’ve previously written about setting up a sETH-WETH pool on Balancer because I was trying to avoid impermanent loss in my early DeFi adventures.
Divergence in asset values is also fine. Even if two assets each have high volatility, that’s still acceptable as long as they tend to trade back to a mean ratio over time. Traders like volatility, which means you’d still be able to collect huge fees from their participation in the market. You’d just have to endure longer periods of pronounced impermanent loss, but they would even out in the medium term.
Let’s say you believe BAT/ETH bounces around in a well defined band. You can still walk away with liquidity provider profits. This weekly chart shows that despite BAT/ETH trading in a wide range, it has only traveled sideways from July 2018 to July 2020. This is ideal for market makers.
BAT/ETH showed mean reverting behaviour over a 2 year period, despite high volatility.
SushiSwap is a great example. Put liquidity into a pool, such as ETH and UMA. Even with prices fluctuating, high SUSHI token rewards to liquidity providers will help you mitigate the risk of impermanent loss. Sell your SUSHI tokens back to ETH or UMA, or stake it for future income as XSUSHI, and you should be compensated and subsidised for the risk you’re taking.
So let’s summarise. Recall these parts of the story earlier in the analogy of the wrestling match.
1. A wrestling match is like a liquidity pool
2. The wrestlers are like the pool’s tokens
3. The one that outperforms earlier bleeds out
Now to wrap up I’m adding in 3 more story points, which you should understand by now:
4. The underperforming opponent catches up
5. It’s a back and forth struggle for dominance
6. The match increases in value as a whole
So, back to the story. After my strong start I was derailed when I got smacked in the head with the garbage and blood began pouring down my face. That gave my opponents a chance to rally and increase in value.
After sucking around for a few more minutes, it was time for the comeback.
Just like any mean reverting trade.
I introduced a trash can lid violently to one of my opponents, in a way that made the commentary team start hyperventilating while comparing me to Captain America.
I turned to grab the other, flinging him overhead into a ladder propped up in the corner of the ring. The ladder snapped like a twig and the crowd lost their shit. All this action was giving them their money’s worth.
Now our little liquidity pool of 3 wrestlers was balanced again. We had eliminated the impermanent loss among ourselves, with each wrestler taking his turn to shine in front of the fans. The audience was riding the emotional rollercoaster, rooting for their favourites. It’s like fees being paid to the market. The liquidity pool was growing in value.
And that’s it for today! This article should help you understand impermanent loss in DeFi AMMs better, what exacerbates it, and 3 strategies to help you avoid the painful experience of losing money when you should be winning!
Original photos by Calvin Alexi. Video by Samurai Studios Network.