A common investment strategy in DeFi is providing liquidity to automated market makers (AMMs). This is done by locking one’s capital in liquidity pools, which usually hold certain specific pairs of assets. This can be very profitable, with returns being generated in terms of trading fees as well as rewards on staked LP tokens.
As with all investments, higher returns usually imply higher risks. One risk specific to providing liquidity arises from the relative volatility between pooled assets, and is known as Impermanent Loss (IL).
Volatility can lead to large gains or large losses when holding a given asset; and many cryptocurrencies experience extreme price swings on short timescales. When participating in a multi-asset liquidity pool, however, the effects of this volatility becomes further complicated due to the relative price change between the assets.
Let’s examine a scenario based on an ETH-DAI liquidity pool, on a platform like Uniswap. The objective of this pool is to maintain a healthy liquidity for traders who are transacting between these two assets. Our user in this case, a liquidity provider, has deposited $500 of ETH and $500 of DAI into the pool. Liquidity providers, such as our user, aim to profit from the pool’s trading fees as well as any rewards which they may receive in exchange for depositing their capital.
At the time of the deposit, ETH’s market price is $3000, and DAI, a stablecoin, is worth $1. After some time, the market price of ETH rises to $4000 while DAI remains stable at $1. In other words, the same amount of ETH is now worth a greater amount of DAI than before.
The relative value of these two assets within the pool is determined by their staked ratios. This means that after ETH has risen in value in the general market (the user’s stake going up in value to $666.67), it is still priced at a lower value within the pool — because the adjacent asset, DAI, remained the same in value ($500).
When a rise in the market price of ETH occurs, the ETH in the pool is undervalued until it is brought back into balance with the adjacent asset. This is an opportunity for arbitrage.
AMMs rely on arbitrageurs to maintain the consistency of prices between assets with respect to their market values. If the market value of an asset in a liquidity pool rises, an arbitrageur bot will quickly buy that asset (in this case ETH) using the paired asset (DAI) and rebalance prices in the pool, generating a profit for itself in the process (effectively buying ‘cheap’ ETH compared to market prices).
This profit arises essentially as a portion of the gains the liquidity provider would make by simply holding the two assets, rather than depositing them into a pool.
Using an impermanent loss calculator, we can see its effects on the above example:
- Total value from holding the assets: $1,166.67
- Total value from having the assets in a liquidity pool: $1,154.70
- Impermanent loss: 1.03%
Note that the above does not take into account the trading fees which go to the liquidity provider, nor any rewards that may result from the staking of LP tokens. These benefits may well outweigh the impermanent loss by a significant margin.
It’s important to remember that the “loss” is only in comparison to holding the tokens; in both cases, the liquidity provider has made a profit, and any “loss” is only realised when withdrawing liquidity from the pool. However, impermanent loss also occurs when prices fall, amplifying the losses that a user would suffer when compared to simply holding the pair of assets in their wallet or on an exchange.
Providing liquidity has proved to be one of the most popular strategies for users who want to generate yield rather than simply holding assets. To limit the effects of impermanent loss, users can participate in pools of like-assets such as stablecoins, or set the price range over which they are prepared to facilitate trades (for example on Uniswap V3). And for those looking for an alternative that doesn’t expose them to impermanent loss, new and innovative investment strategies are emerging in DeFi based on techniques such as facilitating options and arbitrage.