What exactly is impermanent loss?


It is a situation that arises when two crypto assets are added to a liquidity pool yet their prices diverge significantly over a specified time period. As is well known, in order to provide liquidity on decentralized exchanges, you must pool the equal dollar value of both assets. However, as we all know, nothing is more widespread in cryptocurrency than volatility. This means that the “same dollar value” you contributed to the pool will not last long, and at least one of the two assets you’re locking may experience a price pump or dump at any moment, creating the right conditions for temporary loss to occur.
To illustrate the notion and dispel any misconceptions, let us look at an example.
Assume John is providing liquidity to BNB-Cake via the pancakeswap pool, and let us use the following approximate pricing (to facilitate the calculation process)

BNB is priced at $500.
Cake is $20.
John wishes to secure $500 worth of BNB and $500 worth of Cake (both with the same monetary value), which totals $1000 and is divided as follows:

1 BNB vs. 25 Cakes (totaling $1000).

Are you still with me so far?

So, assuming that the overall value of the BNB-Cake pool is $10000, John’s portion equals 10% of the pool, correct?
Uniswape, pancakeswap, and a large number of other decentralized exchanges use an automated marker maker (AMM) methodology, which demands that the multiplied product of each coin’s supply remain constant.
The constant for the total pools in our example is: 10BNB * 250Cake = 2500.
Traders are free to conduct their transactions via the pool. They can exchange BNB for Cake and vice versa, but if a high number of traders purchase BNB (for example), and a small number purchased Cake, the amount of Cake in the pool will increase at the expense of BNB, which will also increase the price of BNB!
Now, if the price of BNB has increased fourfold to $2000 (while the price of Cake has remained fixed), the constant of the BNB-Cake pool remains constant, but the ratio of assets involved changes.
To return to our tiny example, the new BNB-Cake pool ingredients will account for the following: 5BNB multiplied by 500Cake equals 2500
Consider the case where John withdraws money from the pool. He is, of course, still entitled to a share of 10% of the entire pool, which provides him with the following: 0.5 BNB and 50 Cakes (total $2000)
John has forfeited some of his BNB in exchange for extra Cake. Thus, there is no actual loss; but, the ratio of the money has changed, and if John had waited until the price of BNB returned to its starting level ($500), he would have withdrawn his funds at the same initial ratio. That is the primary basis behind the term “permanent loss.” However, it is a somewhat dubious term because “impermanent” can readily become “permanent” if the price of one of the assets changes and never returns to its previous level (BNB in our example)

Another interesting fact is that John ended up with a total of $2000, which means he doubled his initial investment of $1000. However, had John not provided liquidity in the first place and simply held his 1 BNB and 25 Cake, he would have ended up with a total value of $2500 (considering the new BNB price), so some potential profits have been lost due to impermanent loss.

Finally, I should emphasize that this scenario did not include any revenues realized through providing liquidity, which may have covered any losses…

Well, I’m one of those who believes the Defi space will radically transform the economic world. That being said, because Defi is still so new and hasn’t been tested for a long time, we must be alert to the possibility of hidden risks.

Elikem Codda

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