🔴Impermanent Loss
This is a risk investors take when providing liquidity for any pair.
Last updated
This is a risk investors take when providing liquidity for any pair.
Last updated
This risk is related to providing liquidity, that is, when adding a pair of tokens in a broker. If you don't intend to do this procedure, don't worry.
In summary, the impermanent loss is the difference in the value in U$ between holding the tokens in your portfolio or applying them to a pool of liquidity. This difference happens in moments of high volatility, when one of the pair's tokens varies a lot in price. The loss becomes permanent if, at the time of withdrawal from liquidity, the volatile token does not return to its value at the time of addition.
Avoid investing large amounts without understanding the risks of impermanent loss. For volatile tokens, this can represent loss on your investment that needs to be taken into account when analyzing the expected yield (APY).
As of this writing, the DailyDeFi website provides an IL (Impermanent Loss) calculator that allows you to estimate the impacts of price change. Do your own research (DYOR).
To simulate the effects of the impermanent loss on liquidity, we analyze the following scenario when applying liquidity to the AURO/BUSD pair:
By providing liquidity, we are applying Auro and BUSD in order to allow people to buy and sell AURO at any time, without needing another person.
Assuming you invested $10 in this liquidity with 1 Auro = 0.10 BUSD as follows:
Token
Unit Value in Dollars
Deposited Quantity
AURO
U$ 0,10
50
BUSD
U$ 1,00
5
From that moment on, you have a small share in the pool of Auros and BUSDs represented by your VLP tokens (tokens received by adding liquidity).
Let's assume that the total size of this liquidity is:
Token
Total in the liquidity pool
AURO
50.000
BUSD
5.000
Therefore, you have 0.1% of the total liquidity, no matter your proportion or distribution between AURO or BUSD.
After providing liquidity, you must apply VLP tokens in farming to receive rewards for doing so. Assuming that the yield of the AURO/BUSD pair is 1000% per annum. This means that at the end of 1 year you will have received 10x the value added in Auro rewards (83% per month, 2.73% per day).
Of course, these values tend to change over time, depending on how many people are present on that farm (specifically, on this pair) and the unit value of AURO.
When removing liquidity, if there is no variation in the price of the tokens involved (in this case, AURO and BUSD), you will receive the same amount invested.
Depending on platform policy, there may be deposit and withdrawal fees in addition to transaction fees. Usually they tend to be negligible in the long run.
Assuming that many people are buying AURO, that is, they are depositing BUSD and withdrawing AURO from that pool you are part of. This makes the value rise to 1 AURO = $0.20.
By the generic mathematical formula that governs the value of an asset in a decentralized exchange, the composition of the liquidity pool after this appreciation will be:
Token
Total in the liquidity pool (approx.)
AURO
35.355
BUSD
7071
If you decide to withdraw your share of liquidity, you will be withdrawing 0.1% of this current composition, that is:
Token
Unit Value in Dollars
Withdrawn Quantity
AURO
U$ 0,20
35,35
BUSD
U$ 1,00
7,07
If you choose to convert these amounts back to dollars, you will receive $14.14.
This amount is greater than the $10 invested initially, however note that it is less than if you had insured the 50 Auros and the 5 BUSDs (that would make a total of $15). This variation of approximately 5.7% that you failed to gain by placing your tokens in the liquidity pool is called an impermanent loss and it happens whenever only one of the assets in the pair changes.
It is called an impermanent loss because it only becomes permanent if you withdraw liquidity before the asset's value returns to the moment of adding liquidity.
Assuming many people are selling AURO, ie they are depositing AURO to withdraw BUSD from the pool you are participating in. This caused the unit price to drop from US$0.10 to US$0.05.
Following the same mathematical formula for pricing, the composition of the liquidity pool becomes:
Token
Total in the liquidity pool (approx.)
AURO
70.711
BUSD
3.535
If you decide to withdraw your share of liquidity, you will be withdrawing 0.1% of this current composition, that is:
Token
Unit Value in Dollars
Withdrawn Quantity
AURO
U$ 0,05
70,71
BUSD
U$ 1,00
3,53
If you choose to convert these amounts back to dollars, you will receive $7.06.
If you had not invested your AURO and BUSD in the pool, you would have a total of $7.50. Note that there was also a loss of approximately 5.7% between holding the tokens and applying them to liquidity. This is also due to impermanent loss.
Deciding whether an investment is viable is up to the investor himself. It is always necessary to take into account several factors, including: (de)valuation of assets, impermanent loss and whether the gains will be sufficient to offset the risks.
It's not without reason that stable pairs (like USDC/USDT) tend to pay around 10% a year, while unstable pairs (like AURO/BNB at the time of launch) can pay around 110% a day.
