SuperEx丨What’s Impermanent Loss and How to Avoid It
#SuperEx #ImpermanentLoss #AMM
Impermanent loss refers to the temporary loss incurred by liquidity providers (LPs) in an Automated Market Maker (AMM) environment due to market price fluctuations. When prices rise or fall, the value of assets obtained after withdrawing liquidity may be lower than the value of simply holding the assets. This loss occurs because of the constant product pricing mechanism of AMM. As prices revert, impermanent loss will gradually diminish.
Example of Impermanent Loss
Assume a liquidity pool contains 1,000 POL and 500 USDT, with a constant product of 1,000 * 500 = 500,000. Liquidity provider Lares holds 10% of the POL/USDT pool, or 100 POL and 50 USDT, where 1 POL = 0.5 USDT.
Over time, the price of POL increases, changing the asset ratio to 500 POL and 1,000 USDT. The constant product (500 * 1,000 = 500,000) remains unchanged, and 1 POL = 2 USDT. Lares’ share changes to 50 POL and 100 USDT.
If Lares withdraws liquidity, they will receive 50 POL and 100 USDT, valued at 50 * 2 + 100 = 200 USDT.
If Lares had held 100 POL and 50 USDT without providing liquidity, their assets would now be worth 100 * 2 + 50 = 250 USDT. The difference (50 USDT) represents impermanent loss.
Note: Transaction fees are excluded for simplicity.
Why Is It Called “Impermanent”?
The term “impermanent” refers to the fact that this loss is not realized until the liquidity provider withdraws their assets. If the asset prices return to their original levels, the loss disappears entirely. However, in real-world markets, prices rarely revert perfectly, which could make this loss effectively permanent.
How to Avoid It？
Key Factors Influencing Impermanent Loss
Price Volatility
The greater the price fluctuation between the assets, the more severe the impermanent loss. Liquidity providers often favor less volatile asset pairs (e.g., stablecoins like USDT/USDC) to mitigate this risk.
Time Horizon
Impermanent loss is independent of time but is directly tied to price changes. However, over time, trading fees or other rewards may offset the loss.
Type of Liquidity Pool
Certain AMMs (like SuperEx AMM) are specifically designed to minimize impermanent loss, particularly for stablecoin pairs.
How to Mitigate Impermanent Loss
Choose Low-Volatility Assets
Providing liquidity for stablecoin pairs (e.g., USDT/USDC) reduces the risk of impermanent loss due to minimal price fluctuations.
Leverage Trading Fee Rewards
Many AMM protocols reward liquidity providers with trading fees. These rewards can offset or even surpass impermanent loss in some cases.
Use Optimized AMMs
Advanced AMMs, such as SuperEx’s AMM feature combined with an order book, implement efficient liquidity management to reduce impermanent loss.
Diversify Investments
Spread your funds across multiple pools to reduce the risk associated with a single pool’s asset price volatility.
Impermanent loss is a crucial risk for DeFi liquidity providers to consider. While it can impact overall returns, users can mitigate this risk and maximize their earnings potential in DeFi by selecting stable trading pairs, utilizing fee rewards, adopting optimized AMM protocols, and diversifying their investments.
