You may have heard of Impermanent Loss when providing Liquidity to a Liquidity Pool, but do you actually know what impermanent loss is? We will try to explain what Impermanent Loss is in simple terms!
We have to remember that Impermanent Loss is actually only temporary loss of funds occurring when providing liquidity. When you provide liquidity to a liquidity pool you have to provide 2 assets for liquidity and both at the correct ratio.
Let’s take an example with USDT and ETH, you would need to provide in value a 50/50 ratio at the time when you provide liquidity.
Part and parcel of providing liquidity is also gaining trading fees which help to offset the impermanent loss.
Here is an example of providing liquidity on a 50/50 ratio
ETH at $100 (at time of providing liquidity) x 100 ETH
and you also provided 10000 USDT.
Now imagine that after you have provided the above liquidity ETH jumps from $100 to $120.
As a Liquidity provider you would have the following
91.29 ETH and 10954.45 USDT
If you look at the above you would be down in terms of $$ since ETH is now $120 and not $100. The reason why this is called impermanent loss is simply because you are down by an xx amount only on paper.
The Permanent loss only kicks in if you were to withdraw that liquidity from the pool.
To combat the impermanent loss liquidity providers give you a certain amount back from the fees that they collect on the exchange.
Once you provide Liquidity, you gain “Liquidity Provider” tokens also known as LP. Those tokens you need to freeze. The more LP tokens you have the higher % of the pool you own, which in terms means the more fees you will collect from buyers/sellers from the pool. In the above example we have used the example as if you had 1% of the total pool and 0.3% of fees gained.
As price can be volatile during times in crypto your impermanent loss will fluctuate literally nonstop. The more volatility and buy and sell orders happening the more fees you collect as a Liquidity Provider.
Remember there is a reason why it is called impermanent loss, it is only permanent if you take out the liquidity at the point in time where you would be in a loss. Of course if the price were to return to the same value when you provided the liquidity, your impermanent loss would disappear and you would bear the fruits of gaining fees from providing the liquidity.