Luke Willis

Impermanent loss

published9 months ago
1 min read

As I said yesterday, providing liquidity isn't a great experience at the moment. It's hard to do. But people will put up with difficult experiences if there's profit to be made. The main reason for wanting to provide liquidity is to earn interest on your deposits.

The problem is your profits aren't guaranteed. Impermanent loss is the idea that you can lose out on some returns if prices diverge (it's also called divergence loss). Basically, if you provide Eth and Koin liquidity and at the time of your deposit 1 Eth was worth 1 Koin (hypothetically), then you'll keep 100% of your deposited value + interest as long as that 1:1 ratio remains true.

But if the prices diverge in either direction (1:2 or 2:1) then liquidity providers would have been better off just holding their original deposit. You lose a % of your original value as a result of the math needed to balance supply and demand for swaps.

In theory, this divergence loss can be covered by the fees charged to people using your liquidity to swap between the two currencies. But this still feels risky. Why would I want to lose money? There's a mental hurdle there that reduces accessibility.

Impermanent loss is just one issue with defi (decentralized finance). In your everyday life, you never have to think about these things. The exchange rate between currencies (let alone how that's calculated) doesn't make much difference when you're at the market buying groceries. If the general public is supposed to use defi to take economic power away from centralized entities, the whole space needs to be simplified. I shouldn't have to understand the various algorithms that drive pricing on a decentralized exchange. I just want to add value and earn money for doing so.

More on Monday,


P.S. Defi is a much broader topic than liquidity and impermanent loss. I'll address it more broadly soon, but if there are specific sub-topics you want to hear about, let me know.