Impermanent Loss is an event in which a Liquidity Provider, suffers a potentially temporary loss due to a change in the values of the coins held within the pool. Liquidity Providers or LPs, are attempting to provide both coins in a correct ratio to prevent arbitrage while also incurring fees through the process of ‘Liquidity Mining.’
To best understand Impermanent Loss, it’s best to have a grasp of the purpose of a Liquidity Pool and why Liquidity Providers are incentivized to provide liquidity to Decentralised Finance in the first place.
In DEFI or Decentralised Finance, Liquidity Pools serve to create a fairly stable price index between the trading partners within the market. These LPs will provide the liquidity for two or more coins, and attempt to create an equity of supply and value between those coins.
By providing the initial stake, or liquidity for the trading of these coins to take place. This allows for a consistency of trade while simultaneously incurring profits by collecting fees charged to users of their liquidity. This can be referred to as ‘Liquidity Mining’, as it yields the Liquidity Providers with specialized tokens in proportion to their stake in the pool. Therefore creating a positive feedback loop that incentives further stakeholders to add to the pool, drawing more traders to trade off the strength of the liquidity.
Impermanent Loss In DeFi The Risks Involved In Providing Liquidity
Liquidity Providers attempt to create an equity of value by maintaining a balanced ratio between the coins held within the pool. However, there are many different coins that exist in various states of volatility and stability and this creates risk for LPs.
Impermanent Loss is when the external value of one or more of the coins held in the pool changes. This creates a price discrepancy that allows for arbitrage. Arbitrage takes place when the arbiters can take advantage of a price discrepancy in two different markets. Buying or selling at the discount price point and profiting on the difference on the global price point.
This event of arbitrage creates the state of Impermanent Loss incurred by the Liquidity Provider. The loss only becomes ‘Permenant’ if the Liquidity Providers remove their stake from the pool. Now suffering the value difference of coins held within the Liquidity Pool in contrast to the global value of the coins.
Different Liquidity Pools use different means of preventing Impermanent Loss for their Liquidity Providers. Uniswap for example uses a ‘Constant Market Maker’ that analyses and adjusts the coin value ratio in accordance with price oracles. This drastically reduces the likelihood for arbitrage and incurring Impermantent Loss for the Liquidity Providers. Thus making it an attractive opportunity for Liquidity Providers and boosting the strength of the liquidity pool for traders.