Exploring Impermanent Loss
Key readings to grasp the risk associated with liquidity provision in Foccus.io Vaults and Uniswap v3
Last updated
Key readings to grasp the risk associated with liquidity provision in Foccus.io Vaults and Uniswap v3
Last updated
Participating in liquidity provision, whether in Vaults or Uniswap v3 Pools, exposes you to a phenomenon known as impermanent loss. It's crucial to distinguish impermanent loss from actual financial losses experienced by liquidity providers in a DeFi setting. Impermanent loss essentially quantifies the opportunity cost or the risk of ending up with a lower value than if one had simply held onto the assets or if the position is closed.
Foccus.io's cutting-edge protocol aims to markedly diminish the rates of impermanent loss. This is accomplished through proactive management and rebalancing of Vault assets within Uniswap v3's defined, active price ranges. Such measures not only generate significant income from trading fees, countering the effects of impermanent losses but also, in certain scenarios, allow for strategic asset rebalancing. This strategy can lead to the total mitigation of impermanent loss, ensuring full capital protection for our users.
We have curated a list of crucial articles that explore the notion of impermanent loss and offer insights on computing it for your positions within the Foccus.io Protocol.
Calculating the Expected Value of the Impermanent Loss in Uniswap
Impermanent loss is the term used to describe the potential decrease in value that assets might experience when contributed to a liquidity pool. This form of loss usually occurs when there is a shift in the proportion of tokens in the pool, leading to an imbalance. It's crucial to recognize that impermanent loss is not actualized until the assets are withdrawn from the pool. The evaluation of this loss involves comparing the worth of your tokens if they remained within the pool against their value if they were simply held outside the pool. Liquidity pools that involve stablecoins, known for their price steadiness, tend to be less prone to impermanent loss due to their minimal price volatility.
Impermanent loss is particularly impactful in liquidity pools that aim to keep a fixed ratio of tokens, commonly a 50/50 split. For example, in a USDC/ETH pool, participants must supply equal values of USDC and ETH. This requirement entitles them to a proportional stake in the pool's assets. During transactions executed via the pool on decentralized exchanges, the ratio of tokens may vary due to changes in supply and demand, affecting their respective values.
To understand this better, consider a scenario where a liquidity provider contributes 1 ETH and 100 USDC to the pool when both are valued at $100 each, equating to a total investment of $200. If the pool initially contains 10 ETH and 1,000 USDC, maintaining a perfect 50/50 balance, the provider secures a 10% ownership in the pool, represented by LP tokens. These tokens signify the right to reclaim a 10% share of the pool's assets.
Should ETH's price double to $200, the pool's composition would adjust to 7.071 ETH and 1,414.21 USDC to account for the new valuation, disturbing the initial 50/50 balance and affecting ETH's pool price.
With a 10% stake, the provider is eligible to withdraw 0.7071 ETH and 141 USDC, summing up to $282 in value. Yet, by simply holding the initial 1 ETH and 100 USDC, their assets would now be valued at $300. This $18 difference illustrates the impermanent loss incurred due to the shift in pool ratio—a larger discrepancy would amplify the loss.
The magnitude of impermanent loss varies with the pool's asset types and the volume of participants. In the given example of an ETH/USDC pool, ETH is considered a volatile asset against which USDC provides stability. In contrast, a pool involving ETH and LINK, both of which are volatile, would exhibit a heightened risk of impermanent loss. On the flip side, pools containing solely stablecoins, such as DAI/USDC, present a lower risk due to their inherent price stability.
The accompanying graph depicts the relationship between price changes and impermanent loss. A 500% increase in a token's price could lead to an impermanent loss of about 25%, equating to a 25% diminution in potential value had the tokens been held outside the pool.
Given that decentralized exchanges employ mathematical formulas to determine the adjustment in token values when their ratio shifts, utilizing an impermanent loss calculator can simplify the process of estimating potential losses. Here's a reference to the kind of impermanent loss calculator you might encounter, designed to facilitate straightforward calculations of such losses.
In this example, Token A is $100 and Token B is $1, with a total starting value of $1000 between the two tokens — this is set automatically by the calculator. In the “future prices” section, the value of Token A, has increased to $200 while Token B, has remained at $1.
Using a hypothetical scenario where Token A and B are each valued at $500, if they were held outside a liquidity pool, their combined value would stand at $1,500. However, within a liquidity pool, their value might drop to $1,414.21, leading to an impermanent loss of $85.79.
This calculation serves as a basic example to illustrate how impermanent loss functions. For personalized calculations, adjustments can be made based on the actual amount you're considering. For instance, if you were to engage with $2,000 worth of both tokens, effectively doubling the initial example, the impermanent loss incurred would increase to $171.58.
For a more tailored analysis, you might explore tools like the impermanent loss calculator available at decentyields.com/impermanent-loss-calculator. This resource allows for detailed inputs, including your specific deposit amounts, the pool's token ratio, and its weight, enabling a more precise calculation of potential impermanent losses.
In this specific scenario, let's consider the price of Ethereum (ETH) surging by 100%, whereas Tether (USDT) maintains its stability. Here, on an initial investment of $4,000, the profit realized from the liquidity pool (Pool P/L) stands at $1,656. Yet, due to impermanent loss, which amounts to 5.7%, there's a resultant loss of $344. This loss is determined by calculating the difference between what the value would be if simply held ($6,000) versus the actual pool value after price changes ($5,656), which equals $344.
The limitation of this approach is that calculations are based solely on the current value of a token. This means if you initially purchased the token at a price lower or higher than its present value, the calculator does not accommodate adjustments for such scenarios. For those seeking comprehensive data analysis, it might be necessary to employ various calculators. As of now, there isn't a single calculator available that encompasses all essential functions and data points required for a thorough impermanent loss assessment.
The Impermanent Loss Rate of the Uniswap v3 AMM (Math)
