This is one of the biggest issues with yield farming. Crypto is a volatile market, sometimes big moves in token prices. Given how the AMM functions – the price of the assets in the pool is the ratio between them in the pool (the liquidity is constant, but the token ratios can change)
Bob deposits 1 BOO & 100 USDC in a liquidity pool. As mentioned above, the deposited tokens need to be 50:50 ratio. This means that
- 1 BOO = $100
- 100 USDC = $100
- Bob has deposited $200 in USD value to the pool
The pool size is 10 BOO and 1,000 USDC. This gives Bob 10% share of the pool.
Now, let’s assume BOO goes from $100 to $400. Remember, an AMM determines the price of the assets in the pool as the ratio between them in the pool. Now that BOO is $400, the ratio has changed. There are now 5 BOO & 2,000 USDC.
Bob decides to withdraw his 10% (share of pool) in funds. As a result, Bob can with draw
- 0.5 BOO
- 200 USDC
- Totaling $400 USD value
Profit has been made, however, 1 BOO is now worth $400. If Bob had held his tokens in his wallet he would have been better off.
- 1 BOO = $400
- 100 USDC = $100
- Totaling $500 USD value.
This is an excellent example of impermanent loss (IL), and Bob would have been better off keeping the tokens in his wallet. The loss wasn’t substantial, but as you scale up the number of tokens in the pool, the impermanent loss could lead to significant losses.
However, DEXes are aware of this issue, and this example has not considered the rewards received from staking in a liquidity pool. Usually, the rewards outweigh the IL risk. But impermanent loss is a crucial concept to understand before you start adding liquidity to LPs.
Be extra careful when you deposit your funds into an AMM. As a simple rule, the more volatile the assets are in the pool, the more likely you can be exposed to impermanent loss. It can also be better to start by depositing a small amount. That way, you can get a rough estimation of what returns you can expect before committing a more significant amount.