If you have provided liquidity to AMMs (automated market makers) such as Uniswap or you plan to do so, you might have heard of the term ”impermanent loss”.
Well, what exactly is impermanent loss? How to avoid impermanent loss?
In this guide, I’ll explain what impermanent loss is without going into complex technical details and give you some tips to help you minimize impermanent loss as a liquidity provider.
What is impermanent loss? Impermanent loss explained
As you probably know, in order to add liquidity to a trading pair on Uniswap, you need to deposit an equal value of each token in a pair into the pool.
Let’s say you have $500 worth of ETH and $500 worth of UNI in your wallet, and you want to add liquidity to a UNI-ETH pool. Depending on the price of each cryptocurrency, let’s say you currently hold 0.83 ETH and 128 UNI.
Now 1 ETH equals to 154.21 UNI. But, after you deposit your ETH and UNI into the pool, this ratio will change as both cryptocurrencies will change in value and trades take place. As a result, there will be more UNI and less ETH or vice versa in the pool.
So what happens when the exchange rate deviates from the initial rate at which you provided liquidity to the pair? You have impermanent loss. But how does it happen?
As the initial exchange rate and the amount of each token in the pool have changed, when you remove your liquidity from the pool, you will have more ETH and less UNI or less ETH and more UNI. Something like this: 0.60 ETH and 150 UNI or 1 ETH and 105 UNI.
Now what happens is that if you just hold your 0.83 ETH and 128 UNI in your wallet instead of depositing them into a liquidity pool, you could make more money in USD.
To calculate your impermanent loss, you should calculate how much would 0.83 ETH and 128 UNI be worth right now if you just hold, and how much, let’s say, are 0.60 ETH and 150 UNI worth right now (your removed liquidity).
The graph below can give you an idea how big your impermanent loss might be depending on the price change:
A 2x price change results in a 5.7% loss relative to holding, and a 5x price change brings about a 25.5% loss relative to holding.
You earn trading fees when you add liquidity to a liquidity pool which is the main reason why liquidity providers exist.
But, most of the time, as cryptocurrency pairs can be quite volatile, impermanent loss exceeds fee earnings leaving liquidity providers with loss.
How to avoid impermanent loss?
You can’t actually avoid impermanent loss. But there are various ways to mitigate it. Here are 6 ways to mitigate your impermanent loss as a liquidity provider.
1- Providing liquidity to stablecoin pairs
You can provide liquidity to liquidity pools that consists of two stablecoins such as USDC-USDT. This might be the best way to get rid of impermanent loss. But this way you can’t enjoy the rise in the market as you hold stablecoins.
In a bull market, it might not be a good idea to hold stablecoins and provide liquidity to a such pair as you will not be exposed to crazy returns.
But, in a bear market, you can provide liquidity to a pair like USDC-USDT and earn trading fees while not losing any money in the falling market.
2- Avoiding risky and volatile cryptocurrency pairs
Let’s say you want to provide liquidity to the LINK-ETH pair on Uniswap. If you think that LINK will significantly outperform ETH or vice versa, don’t do it because you will be more exposed to impermanent loss.
If both LINK and ETH rise or decrease in value relative to each other, then you’ll be fine as the initial exchange rate will not change much.
The idea here is not to avoid volatile cryptocurrencies but to consider the future performance of both cryptocurrencies in a pair against each other.
3- Providing liquidity to pools with unevenly weighted cryptocurrencies
Most AMMs are forks of Uniswap with new features or underlying mechanisms. But they are overall very similar to Uniswap.
Among Uniswap competitors, Balancer is very different than other AMMs in that it allows users to create pools with more than two tokens, set different weights for each token and charge a trading fee between 0.0001% and 10%.
While every pool on Uniswap consists of two tokens with equal weights, you can find pools with unevenly weighted tokens such as 75% MKR 25% WETH on Balancer.
Well, what’s the importance of this with regard to impermanent loss? What happens when you provide liquidity to a 75% MKR 25% WETH pool instead of 50%-50% one?
If you provide liquidity to a 75% MKR 25% WETH pool and MKR rise against WETH, you will suffer less from impermanent loss compared to providing liquidity to a 50% MKR 50% WETH pool.
So, if you are bullish on MKR and think it will outperform ETH, instead of providing liquidity to a 50% MKR 50% WETH pool, you can provide liquidity to a pool like 75% MKR 25% WETH on Balancer.
In this way, you can suffer less from impermanent loss when the token you are bullish on rises. But, if things don’t go as you expected and ETH outperforms MKR, your impermanent loss will be greater in a 75% MKR 25% WETH pool compared to a pool with equally weighted MKR and WETH.
4- Providing liquidity to incentivized pools and participating in liquidity mining programs
All of the popular AMMs have their own tokens which are distributed to liquidity providers through liquidity mining programs. Among them, the most popular ones are UNI and SUSHI.
In order to minimize your losses as a liquidity provider, you can participate in liquidity mining programs or provide liquidity to incentivized pools. Some projects distribute their tokens to those who provide liquidity to a certain pair on AMMs such as Uniswap and Balancer, which you can check out here.
5- Providing liquidity to Mooniswap (1inch Liquidity Protocol)
Mooniswap is an AMM launched by the 1inch team. As a Uniswap competitor, it aims to lower impermanent loss for liquidity providers with its different approach to exchange rates.
Mooniswap introduces virtual balances which decreases the profit of arbitrageurs due to temporarily mispriced pools, leaving more profit for liquidity providers.
According to Mooniswap’s whitepaper, the team expects Mooniswap to generate from 50% to 200% more income for liquidity providers than Uniswap due to redirection of price slippage profits.
As of now, there is a total liquidity of $100M on Mooniswap while Uniswap has a total liquidity of $1.78B. As expected, there is much less volume on Mooniswap which means less fees for liquidity providers.
So, if you want to provide liquidity to a pair on Mooniswap, you should also consider the volume and liquidity of that specific pair on Uniswap.
Update: With the launch of 1INCH token, Mooniswap has been deprecated and rebranded to 1inch Liquidity Protocol.
You can check out our 1inch exchange review to learn how to use and add liquidity to 1inch exchange.
6- Not removing liquidity till the exchange rate returns to the initial rate
After you provide liquidity to a pair, the initial rate at which you provided liquidity to the pair will change, which is quite normal. But, if the exchange rate even more deviates from the initial rate, your impermanent loss will be much greater.
You can wait for the exchange rate to return to the initial rate and exit the liquidity pool with almost no impermanent loss. But it is not as easy as it might seem considering the volatility in the cryptocurrency market.
Instead, you should assess the cryptocurrency market and carefully research about each token in a pair before providing liquidity into a pool.
Also, you should be willing to exit the liquidity pool with some impermanent loss at some point.
To learn how to add liquidity to decentralized exchanges, check out our decentralized exchange reviews below: