What is Impermanent Loss, and How to Reduce It in Automated Market Makers

Research suggests that global Decentralized Finance (DeFi) platform markets will reach $507 billion in 2028, which would indicate a compound annual growth rate of 43.8%. One of the fundamental protocols of DeFi is the automated market maker. They provide liquidity to allow digital assets to be traded in a permissionless and automatic way.

Unlike traditional financial markets that rely on market makers and takers, DeFi relies on automated market makers for liquidity.

One of the inherent design characteristics in automated market makers is what’s known as impermanent loss (IL).

It’s important to understand impermanent loss if you want to provide liquidity as an automated market maker.

Automated Market Maker in DeFi

The Automated Market Maker (AMM) is a decentralized exchange (DEX) protocol that has an autonomous trading mechanism to remove the need for a centralized entity.

Rather than employing a typical order book, AMMs price assets according to a pricing algorithm.  The AMM enables a user and a smart contract to exchange assets directly by eradicating all intermediary processes.

Thus, trades are peer-to-contract (P2C) rather than peer-to-peer (P2P).

AMMs have become popular because liquidity providers can earn transaction fees in exchange for their liquidity and creating volume. However, AMMs also have a downside: they are subject to impermanent loss.

What is impermanent loss?

Impermanent loss is one of the biggest drawbacks of AMMs.

IL occurs if the price of a token significantly differs from when a liquidity provider deposited it into the liquidity pool. This happens when the price ratio of pooled pairs significantly fluctuates.

The risk grows as the amount of change gets bigger. This type of loss is more common in liquidity pools with volatile assets.

The loss is “impermanent” because the price ratio is expected to revert. Impermanent loss assumes that the losses will be mitigated when the assets return to their prices at the time of deposit.

How impermanent loss occurs

When the rebalancing formula for an AMM's driven token generates a disparity between the price of an asset in a liquidity pool and its market price, an impermanent loss occurs.

Because AMM formulas prioritize a ratio balance, the asset value of your pool may differ from its market value. Thus, if you were to sell your tokens out of the liquidity pool, you would suffer a loss.

For example, let's assume you have deposited equal amounts of XRP and BUSD into an XRP–BUSD liquidity pool. The AMM dictates that the value of this pair be balanced. Note here that DeFis are independent of external markets' pricing.

Hence, when the price of XRP skyrockets on exchanges, arbitrageurs may take advantage of market discrepancies to make profits.

In our example, arbitrageurs may buy XRP at a cheaper price from the XRP–BUSD pool and sell it at a higher price on other platforms. This creates a high demand for XRP, further increasing its price.

Arbitrageurs may repeat the process until the prices balances. In this situation, arbitrageurs profit at the expense of liquidity providers, who technically own less XRP than they did before.

How to reduce impermanent loss in AMMs

Liquidity mining benefits both traders and liquidity providers. Traders get volume in digital assets and liquidity providers earn interest on their deposits.

However, the process comes with its own risks, especially in volatile markets with fluctuating prices.

However, there are ways to reduce the chances of impermanent losses when rates change.

Choose a single asset pool

One-sided pools only need you to provide liquidity for one token. AMMs like Liquidity and Bread allow you to supply, for instance, a stablecoin to ensure its solvency in the pool.

Liquidity providers are rewarded a portion of the liquidation fees charged on the platform. However, like in stablecoin pools, the risk is low, and so the profit is also low.

Start small and tread carefully.

It’s important to start small when you are still learning the ins and outs of AMMs It's critical to exercise caution in liquidity mining, just like with any other form of cryptocurrency trading.

Additionally, by starting small, you'll experience less frequent losses in a sideways market.

Trade stablecoin pairs

Stablecoin pairs are the most efficient way of evading impermanent losses.

Most stablecoins are tied to the U.S dollar in a 1:1 ratio. Hence, they are not as volatile as other cryptocurrencies.

Some of the pairs you can invest in include USDT–BUSD, DAI–TUSD, and USDT–USDC. The only drawback of choosing stablecoin pools is that the reward is low in bull markets; however, you're safe from IL in a bear market.

Go with flexible liquidity pools

The token ratio is not necessarily 50/50 in some decentralized exchanges.

Some ratios may reach 60/40, or even 70/30. Some platforms like Balancer, even allow users to pool more than two assets.

However, when the price of the asset with the higher percentage fluctuates, the il is greater. Thus, this option can either counteract impermanent loss effects or cause significant losses.

Offset the loss with trading fees

Automated market makers reward liquidity providers with a cut of trading fees collected from traders using the LPs, and these trading fees may sometimes be sufficient enough to make up for any impermanent losses.

Be patient

When you add liquidity to a pool, the prices of crypto pairs naturally change. The risk of permanent loss depends on the extent to which prices deviate from when you deposited the assets.

If cryptocurrency prices don't return to their original values, you may not be able to withdraw your funds. The best thing to do is wait for the price ratio to revert before you can withdraw.

Trade low volatility pairs

Providing liquidity for more volatile assets increases impermanent loss risk. If one asset outperforms the other, then you'll incur an impermanent loss; but if the pair falls or rises against each other, you're good to go.

Either way, it's advisable to stay away from highly volatile pairs.

Bottom line

Regardless of the price movement direction, you may still experience IL. It doesn't matter whether the price of one of the currencies in the crypto pair rises or falls. These are just some of the ways to mitigate the impermanent loss risk in AMMs.

Investors should always do their due diligence before venturing into liquidity mining.