Decentralized finance (DeFi) decentralized exchanges like Uniswap, Curve, and PancakeSwap rely on Automated Market Makers (AMMs) to provide constant token liquidity. Rather than relying on traditional order books with buyers and sellers, liquidity providers (LPs) deposit pairs of tokens (e.g., ETH / USDC) into smart contract liquidity pools.
In exchange for supplying capital, LPs earn trading fee commissions from every swap. However, depositing tokens into an AMM carries a unique financial risk known as Impermanent Loss (IL).
Calculate impermanent loss and net LP yield vs simple holding (HODL): thetoolss.com/tool/crypto-liquidity-pool-impermanent-loss-calculator
What is Impermanent Loss? Impermanent loss occurs when the relative price ratio of the two deposited tokens diverges from when you deposited them. Because AMMs use constant product formulas (x * y = k), arbitrageurs rebalance the pool by buying the appreciating token and depositing more of the depreciating token.
When you withdraw your liquidity, you receive fewer of the outperforming token and more of the underperforming token than if you had simply held (HODLed) both tokens in your private wallet!
Why is it Called "Impermanent"? The loss is only "impermanent" as long as the tokens remain in the pool. If the price ratio returns to its original entry ratio, the loss disappears entirely. However, the moment you withdraw your pool tokens, that impermanent loss becomes permanently realized!
Impermanent Loss Rule-of-Thumb Benchmarks
- 1.25x price change: ~0.6% impermanent loss
- 1.50x price change: ~2.0% impermanent loss
- 2.00x price change: ~5.7% impermanent loss
- 3.00x price change: ~13.4% impermanent loss
- 5.00x price change: ~25.5% impermanent loss
When is Liquidity Providing Profitable? Liquidity providing is profitable when the trading fee APY earned exceeds the impermanent loss percentage incurred during the holding duration. High-volume pools with tight price correlation (such as stablecoin pools like USDC/USDT) carry virtually zero impermanent loss risk.
Calculate overall crypto portfolio profit and loss: thetoolss.com/tool/crypto-profit-loss-calculator-pro