Impermanent Loss White Paper
1. Executive Summary
Impermanent loss is one of the most misunderstood and underestimated risks in decentralized finance (DeFi), particularly among liquidity providers. This white paper explains what impermanent loss is, how it occurs, and the most effective strategies to mitigate or avoid it altogether. Our goal is to empower users with knowledge and practical tools to make informed decisions and protect capital while participating in liquidity pools.
2. What is Impermanent Loss?
Impermanent loss refers to the unrealized loss a liquidity provider experiences when the price of deposited assets changes compared to when they were deposited in a liquidity pool. This occurs in Automated Market Maker (AMM) platforms like Uniswap, SushiSwap, Curve, and Balancer
The loss is considered "impermanent" because it only becomes permanent if the provider withdraws the assets before prices revert to their original ratio. If prices return to their original state, the loss disappears.
Example:
You deposit $500 of ETH and $500 of USDC into a pool (50/50).
ETH price doubles, and arbitrage traders rebalance the pool.
Your share of the pool now contains less ETH and more USDC.
If you withdraw, your portfolio is worth less than if you had simply held the assets.
3. Why Impermanent Loss Happens
AMMs maintain a constant product formula (x*y=k), which means that when one asset rises in value, the pool automatically sells part of it to maintain the balance. This rebalancing benefits traders and arbitrageurs but dilutes the original asset ratio for the LP.
The greater the price divergence, the more loss a liquidity provider experiences compared to simply holding the assets.
4. How to Measure Impermanent Loss
Price ChangeImpermanent Loss
1.25x0.6%
1.50x2.0%
2.00x5.7%
3.00x13.4%
5.00x25.5%
Note: These percentages reflect the loss compared to holding the assets outside the pool.
Even if you’re earning fees, impermanent loss can wipe out gains if not properly managed.
5. How to Avoid or Minimize Impermanent Loss
a. Provide Liquidity to Stablecoin Pools
• Pairs like USDC/DAI, USDT/USDC, or DAI/FRAX experience minimal price divergence.
• These pools are ideal for conservative LPs focused on preserving capital.
b. Use Protocols Designed to Mitigate IL
• Balancer: Allows for custom weight pools (e.g., 80/20 instead of 50/50).
• Bancor v3: Offers IL protection with single-sided exposure.
• Curve: Optimized for like-kind assets (e.g., stablecoins, ETH-staked derivatives).
c. Avoid Highly Volatile or Imbalanced Pairs
• Avoid providing liquidity to tokens that are likely to moon or crash.
• Stay away from low-volume, high-risk meme coin pairs.
d. Enter at Low Volatility Points
• IL is minimized when assets don’t move much in price after entry.
• Entry during sideways market conditions can reduce IL risk.
e. Use Hedging Strategies
• Hedge with options or perpetuals to reduce directional exposure.
• Monitor with on-chain analytics and set alerts for major price shifts.
f. Consider Single-Sided Staking or Vaults
• Someprotocols allow you to stake a single asset and earn yield without being exposed to IL.
• Example: Tokemak, Bancor, Yearn vaults, and others.
6. Tools to Monitor Impermanent Loss
• APY.Vision: Tracks IL and LP performance.
• DeBank/Zapper: Portfolio overviews.
• Revert Finance: Real-time IL analytics for Uniswap positions.
7. Case Study: Stable vs. Volatile Pair
Scenario A: Stablecoin Pair
USDC/DAI pool
Entry TVL: $10,000
Yield: 5% annualized
Impermanent Loss: <0.1%
Net Profit: ~$500/year
Scenario B: ETH/USDC Pair
ETH price increases 2x
Yield: 12% annualized
Impermanent Loss: 5.7%
Net Profit: Negligible or Negative, depending on price action
8. Conclusion
Impermanent loss is real, but it’s not a death sentence. With the right strategy, LPs can minimize or even avoid this risk entirely. Understanding pool dynamics, choosing the right assets, and using hedging tools are critical components of a sound DeFi yield strategy.
Overseas DeFi helps you evaluate and manage liquidity opportunities with a risk-adjusted lens to keep your capital growing with confidence.
Disclaimer: This white paper is for educational purposes only and is not financial advice. Always do your own research before interacting with DeFi protocols.
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