What is IL?
Simply put, impermanent loss (IL) can be calculated when the value of one or both of the underlying tokens in the liquidity pool changes when compared to the price at which the tokens were deposited. This means that if the price of the two assets in the LP do not move perfectly in sync (which can not be expected from two entirely different tokens), a position holder will theoretically have IL. It’s essential to include the word ‘theoretically’ here since IL isn’t something that tangibly occurs to your portfolio. Impermanent loss can only be calculated when you compare the value of your LP position to the value of holding each of the tokens individually in the same proportion.
Why you shouldn’t care about impermanent loss
In the DeFi community, many investors and traders mistakenly refer to the loss of LP value as impermanent loss. The real loss is not generally from IL but from the underlying coins dropping in price relative to stable assets.
Those who are genuinely concerned about IL and not the loss of LP value are often misinformed. The idea that IL poses a significant risk to your holdings is a fallacy. By calculating IL, a user is essentially comparing their current pool’s value to an entirely theoretical one. In other words, it’s like going to one’s money manager and complaining that because the money manager invested in both ETH and BTC and balanced your funds, you made less than strictly holding BTC (assuming BTC appreciated more rapidly than ETH).
To reiterate, when you calculate impermanent loss, you’re comparing your actual portfolio to an entirely hypothetical portfolio- one where you invest in both of the tokens without entering a liquidity pool. While an investor could do this, it’s a useless comparison. If the logic behind impermanent loss held, you could actually calculate impermanent loss relative to all possible investable asset pairs. And of course, if you did that, your IL on every investment would be 100%. It’s simply impossible to construct a portfolio that holds only the highest performing assets.
The concept behind impermanent loss can help you
Impermanent loss is not necessarily a bad thing. It’s more accurate to think of IL as the cost of diversification. According to modern portfolio theory, an optimal portfolio is a diversified one that consists of multiple risky assets. In other words, holding more risky assets lowers the standard deviation of your return, thereby increasing your expected return.
When you hold two risky assets, as you do as an LP, you’re diversifying away some of the risk associated with these tokens. When providing liquidity, it’s common to hold a larger market cap coin and an altcoin, so this diversification is especially useful at minimizing risk.
While it is true that if you held the tokens separately and in an equal proportion, you would still have the benefits of diversification and wouldn’t be exposed to impermanent loss, IL is generally so small that it isn’t worth worrying about.
Here are some estimated levels of IL (you can always click here to calculate your own scenario):
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
I know I shouldn’t care about IL, but how is it derived?
Although impermanent loss can vary based on the rate and velocity of the change in the price of each asset, it can still be estimated with a simple formula:
There’s also this convenient impermanent loss calculator if you don’t want to crunch the numbers yourself.
And if you’re looking for a simple look as to how much IL risk you’re facing, you can consult this chart:
Summary
Impermanent loss isn’t something you should worry about. It isn’t some type of fee taken out of your LP position, and it isn’t a tangible number being withdrawn from your account. It isn’t even that significant of a percentage unless one of the tokens in the pair rapidly appreciates or depreciates relative to the other. Besides, if a token appreciates and the pair doesn’t stay in sync relative to when you deposited into the pool, you’ll likely be too excited about the appreciation to care about the small ‘loss’ from IL, and if they rapidly decline, then you have bigger problems.
In summary, you face a greater chance of loss from simply holding two risky assets than you do from impermanent loss.
About Brink
At Brink, we are building critical infrastructure for conditional orders on DeFi. Brink is a fully permissionless, decentralized, and community-driven project that allows users to execute conditional orders against any on-chain liquidity source.
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Our ninja beta app is live at brink.ninja. The beta is currently closed to users who meet certain criteria for early adopters. Talk to us about joining.
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Disclaimer
We’ve done our best to deploy secure code, but Brink has not been audited by a 3rd party. Like any Dapp, use caution, and be aware that there is always a risk of fund loss.
