Providing liquidity to decentralized finance (DeFi) liquidity pools can be a way to earn yield through trading fees. You deposit a pair of tokens into a smart contract, helping facilitate trades between those two tokens. In return, you get a share of the fees generated by the pool.
However, there’s a significant risk involved that isn’t always obvious at first glance: Impermanent Loss (IL). I learned about Impermanent Loss the hard way when the price of one token in a pair I provided liquidity for changed drastically compared to the other. When I withdrew my tokens, I had fewer overall assets (in dollar value) than if I had just held the original two tokens in my wallet.
Impermanent Loss is something every liquidity provider needs to understand and try to manage. While you can’t always completely avoid it in highly volatile markets, there are ways to significantly reduce your exposure.
What is Impermanent Loss?
Impermanent Loss happens when the price of the tokens you deposited into a liquidity pool changes compared to each other after you deposit them. The larger the price difference (or divergence), the greater the Impermanent Loss.
Think of it this way: When you provide liquidity, you typically deposit an equal value of two tokens (say, Token A and Token B). The pool maintains a constant ratio between the tokens based on trades. If the price of Token A goes up while Token B stays the same, traders will buy Token A from the pool, replacing it with Token B, to take advantage of the price difference. When you eventually withdraw your liquidity, the pool will rebalance, giving you proportionally less of the token that increased in price and more of the token that didn’t.
You end up with a different mix of tokens than you started with. The “loss” is the difference in value between keeping your tokens in the pool versus simply holding them in your wallet (a strategy called “HODLing”). It’s called “impermanent” because if the prices of the tokens eventually return to the ratio they were at when you deposited, the Impermanent Loss disappears. But if you withdraw your liquidity before they return, the loss becomes permanent.
Why Should I Care About Impermanent Loss?
Because Impermanent Loss can cancel out, or even exceed, the trading fees you earn from providing liquidity. You might earn a lot of fees, but if the price divergence is large enough, the value lost due to IL could mean you end up with less total value than if you had done nothing at all.
How to Reduce or Avoid Impermanent Loss
Completely avoiding IL is difficult or impossible in standard liquidity pools with volatile assets. However, you can use strategies to reduce its impact:
Strategy 1: Provide Liquidity for Stablecoin Pairs
- How it works: Stablecoins are cryptocurrencies designed to maintain a stable value, often pegged to a fiat currency like the US dollar 1 (e.g., USDC, USDT, DAI).
- Why it helps: When you provide liquidity for a pair like USDC/USDT, the price ratio between them should ideally remain very close to 1:1. Since there’s minimal price divergence, the Impermanent Loss is negligible or zero.
- Consideration: The trade-off is that stablecoin pools usually have much lower trading volume and fees compared to pools with volatile assets like ETH or BTC.
Strategy 2: Choose Assets with Low Volatility or High Correlation
- How it works: Some asset pairs tend to move together in price (high correlation). Examples might include ETH and Wrapped Ether (WETH), or perhaps ETH and staked ETH derivatives (like stETH).
- Why it helps: If both tokens in the pair increase or decrease in price at roughly the same rate, the ratio between them doesn’t change much. This results in lower Impermanent Loss than pairing a volatile asset with a stablecoin or two completely uncorrelated volatile assets.
- Consideration: Even correlated assets can diverge in price, especially during market volatility or due to specific events affecting one asset. This strategy reduces, but doesn’t eliminate, IL risk.
Strategy 3: Use Protocols Offering Impermanent Loss Protection (ILP)
- How it works: Some DeFi protocols are designed with features that aim to mitigate Impermanent Loss for liquidity providers. Bancor is a well-known example that historically offered ILP. These protocols often use mechanisms like insurance funds or token inflation to cover potential losses.
- Why it helps: If you meet the protocol’s criteria (e.g., staking for a minimum duration), the protocol might reimburse you for some or all of your calculated Impermanent Loss upon withdrawal.
- Consideration: ILP often comes with requirements, like minimum staking periods (e.g., 100 days on Bancor V2.1 for full protection), and the protection might be funded by the protocol’s native token, adding another layer of risk. Research the specific protocol’s ILP model carefully.
Strategy 4: Explore Single-Sided Liquidity or Flexible Pools
- How it works: Some newer or specialized protocols allow you to deposit just one asset into a pool (single-sided) or use more dynamic pool structures where the token ratio isn’t fixed 50/50. Examples include some types of vaults or managed strategies.
- Why it helps: These designs aim to reduce your direct exposure to the price swings of both assets in a traditional pair.
- Consideration: These protocols often involve complex underlying strategies and smart contract risk. You also need to understand how they manage risk and generate yield.
Strategy 5: Focus on Pools with High APY (Yield Farming)
- How it works: Sometimes, the potential earnings from trading fees and additional farming rewards (like receiving the protocol’s governance token) are high enough that they are expected to outweigh the potential Impermanent Loss over time.
- Why it helps: This doesn’t avoid IL, but it makes it less likely that IL will result in a net loss compared to HODLing. You accept the IL risk in exchange for potentially higher total returns.
- Consideration: High APY often comes with higher risk, including protocol risk, smart contract risk, and the risk of the reward token’s price dropping. This strategy is about mitigating the impact of IL on your final return, not avoiding the IL calculation itself.
Strategy 6: Provide Liquidity in Concentrated Liquidity Pools Wisely
- How it works: Protocols like Uniswap V3 allow liquidity providers to concentrate their capital within specific price ranges. You only provide liquidity for the price range where you expect trading to occur.
- Why it helps (potentially): If the price stays within your specified range, you can earn significantly higher fees on your capital compared to providing liquidity across the full price range. This higher fee income can potentially offset Impermanent Loss.
- Why it can hurt: If the price moves outside of your chosen range, your liquidity becomes inactive, you stop earning fees, and your Impermanent Loss can be magnified compared to a full-range pool, as you’ll end up holding only the asset that dropped in price (if price goes below your range) or only the asset that increased (if price goes above your range). This requires active management and a strong price conviction.
Understanding the Trade-offs
Choosing strategies to avoid Impermanent Loss often means accepting different trade-offs:
- Lower Yield: Stablecoin pools or low-volatility pairs typically offer less yield than volatile pairs.
- Platform Risk: Using protocols with IL protection or single-sided liquidity introduces reliance on that specific protocol’s smart contracts and economic model.
- Complexity: Strategies like concentrated liquidity require more active management and a deeper understanding of market dynamics.
Monitor Your Positions
Regardless of the strategy you choose, it’s wise to use portfolio tracking tools that can help you estimate your Impermanent Loss and compare your LP position’s performance against simply holding the assets. This helps you make informed decisions about when to enter or exit a pool. Impermanent Loss is a fundamental concept in many liquidity pool designs. While you can’t always eliminate it, by understanding how it works and employing strategies like choosing stablecoin pairs, correlated assets, using ILP protocols, or managing concentrated liquidity wisely, you can significantly reduce its impact and increase your chances of a profitable liquidity providing experience.
