Impermanent Loss

The rise of Automated Market Makers

With the rise of DeFi, DEX Automated Market Makers as Uniswap, Pancakeswap, Quickswap and Spookyswap have been providing the possibility for users to earn passive income with the cryptocurrencies they hold by becoming liquidity providers. This allows holders to earn from the fees on the swaps carried out using the liquidity pool they own a share of, and to receive the revenue token distributed by the AMM projects. Users are also able to unstake their holdings at any time in a decentralized environment. Sounds amazing, right?

The risk of impermanent loss

However, this does not come without risks. In particular, the risk of impermanent loss may be undervalued or, worst, ignored by the majority of liquidity providers.
In order to understand what the impermanent loss is, it is important to recall that AMMs are based on a constant function, the well-known “x * y = k”. This formula describes how the prices of the tokens constituting the liquidity pool (x and y) are simply determined by the ratio between the constant k and the price of the other token. Because the prices of the tokens in an AMM are determined only by this ratio, they often differ from the prices displayed on Centralized Exchanges such as Binance and Coinbase.
This constantly leaves room for arbitrage opportunities, with traders earning profits from changing the ratio of the two tokens constituting a LP token. As we know, trading is a sum-zero game, meaning that if someone is making profit, then someone else is suffering a loss. In this case, the loss is suffered by the liquidity providers under the form of impermanent loss.
This loss is called “impermanent” because it does not add up as the prices vary, but it becomes effective only once the owner of the LP tokens withdraws its liquidity.

Quantifying this risk

The impermanent loss is the difference between the value of the two tokens if they were just held as single tokens, and the value of the LP token.
Here’s a summary of what the graph is telling us about losses compared to HODLing.
  • 1.25x price change corresponds to a 0.6% loss
  • 1.50x price change = 2.0% loss
  • 1.75x price change = 3.8% loss
  • 2x price change = 5.7% loss
  • 3x price change = 13.4% loss
  • 4x price change = 20.0% loss
  • 5x price change = 25.5% loss
It is also important to recall that the price change is to be taken in absolute value: the direction of the change in price does not matter.

Stablecomp and the Impermanent Loss

Stablecomp is designed to provide an experience to its users that is as stress-free as possible.Because they only use stablecoins and do not use more volatile tokens, the farms hosted by Stablecomp will not suffer any signficant impermanent loss because the price of the tokens constituting the LPs will both converge to the same value.
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The rise of Automated Market Makers
The risk of impermanent loss
Quantifying this risk
Stablecomp and the Impermanent Loss