An Impermanent Loss occurs when, after contributing digital assets to a liquidity deposit, the value of this asset changes, generating an Impermanent Loss. This Loss is compensated with trading commissions and is noticed at the moment of withdrawal of the deposit.
Impermanent Loss is a complex term that occurs in specific circumstances when trading cryptocurrencies. As a user, you can provide liquidity through investment or exchange platforms known as AMM or Automated Market Maker. We explain.
Impermanent Loss: what is it?
To explain what an Impermanent Loss is, we must first define what AMMs are. This acronym stands for Automated Market Maker. They are cryptocurrency exchange platforms that do not take as a reference the ‘official values’ of these digital assets. On the contrary, they use their algorithm to decentralize their value.
They are investment markets that trade cryptocurrencies in a decentralized way and with their values to try to simplify the concept.
In these markets, investors can trade cryptocurrencies, including, for example, maximum and minimum prices at which they are willing to sell a given asset. When someone accepts these prices, the trade is automatically executed.
Impermanent Loss and liquidity providers
The problem arises when this difference can hinder market dynamics since not all buyers are willing to access these securities. That is where liquidity investors come in.
Suppose they contribute with cryptocurrencies into the market so they can carry out operations such as those described above at a lower difference than that proposed by the seller. That is useful because it speeds up market operations.
Why would an investor contribute liquidity? Because the market compensates these liquidity contributions (of cryptocurrencies) with attractive commissions precisely to incentivize them, as they are a high-risk operation. Among other things, due to impermanent losses.
If I contribute liquidity to the market, but the cryptocurrency loses value during the process, I will be generating impermanent losses. This loss will become effective when I withdraw my liquidity, and the value of the cryptocurrency against fiat money (euros or dollars) has changed downwards.
When does Impermanent Loss occur?
The Impermanent Loss moment initially occurs at the very moment when the cryptocurrency varies in value concerning the instant of deposit. However, where would notice it is at the time of withdrawal of liquidity.
At this point, the lost value would become permanent value. At this moment, the possible loss is contrasted with the commissions obtained in the duration of the deposit, pointing to liquidity.
Theoretically, as we saw earlier, it is in this difference that the profitability that can be provided by providing liquidity is obtained. The markets are aware of the risk of impermanent loss and try to compensate it with good commissions for those who decide to provide liquidity to their investments.
When considering trading by providing liquidity in an AMM, it is important to consider the possibility of this situation, as it implies a high risk. Generally, it is advisable not to participate in groups on cryptocurrencies with high volatility and not to do so with large amounts of money. In this way, you can test the platform’s robustness before trading on a more continuous basis.
As usual, when trading in digital assets, it is convenient to have the basic knowledge that should increase depending on the type of investment. Impermanent losses are not exclusive to cryptocurrencies, but they can be one of the main reasons for failure when investing in this type of asset.
Moreover, the mistake is made of thinking that these losses will only occur on liquidity pools, loans or deposits. Even in an investment model based on speculation on the asset’s value, it is already possible to incur a loss of equity while keeping the tokens in staking.
In short, speculation on cryptocurrencies assumes the risk of the change in the value of the assets over the time we have them immobilized. That is a key factor when we seek profitability in the crypto market.