Uniswap and many other decentralised exchanges are automated market makers (AMMs) - that is, protocols which, through the use of smart contracts, enable automatic transactions without a centralised authority. These trades are executed using an algorithm rather than a book of trading orders as on traditional exchanges. We have written about the principle of Uniswap in more detail in this article. We recommend you to read it to understand better what's going on in the niche.

Ultimately, the market is created by liquidity providers. These are people who essentially share money for a certain trading pair, on which other market participants trade. The peculiarity is to share an equivalent volume of two cryptocurrencies. For example, if a person sends one ether to liquidity for an ETH/USDT pair, he must also contribute $4,320 in USDT at today’s Ethereum exchange rate. This keeps the market in balance.

What is an Impermanent loss?

An impermanent loss (impermanent loss or IL) is a loss of funds faced by liquidity providers due to the volatility of a trading pair on a decentralised exchange. As we have already noted, liquidity providers or LPs are people who deposit funds into DEX pools for the sake of profit in the form of transaction fees.

AMMs are governed by a mathematical algorithm that automatically balances the ratio of assets in the pool at 50:50 and thereby determines their value. For pricing, the formula X x Y = K is used, where X and Y are two different assets and K is a constant, which must remain the same before and after a trade. To understand the principle behind IL, let’s look at a simple example of a liquidity provider.

Top liquidity pools on Uniswap

Suppose there are two assets in a liquidity pool, ETH and the stabelcoin DAI. To provide liquidity to the pool, the provider must deposit both coins at equal value. For example, 1 ETH and 4,320 DAI is the current market value of Etherium in DAI. As long as the market price of ETH remains stable, there is no problem, but as soon as it starts to rise, arbitrage traders will start buying ETH out of the pool until the value of the asset on DEX and the other exchanges is equal.

Because of the fact that constant K will remain the same, according to the formula, if the price of ETH will increase, say, four times from conventional 4 thousand dollars, the liquidity provider from the pool will be able to withdraw only 0.5 ETH and 8 thousand DAI. This means that he will receive less ethers, but more stabelcoin, because in this way the balance of two cryptocurrencies in a pair is guaranteed, taking into account the growth of Etherium. So in total he would get 16 thousand DAI or 16 thousand dollars.

But if LP just stores coins instead of sending them to pool, it would have the equivalent of 20 thousand DAI during the same period. The difference of 4 thousand DAI or 4 thousand dollars is the unrealized loss.

It is called non-permanent, because when rates return to previous values, there will be no loss. This means that the loss is only fixed when the liquidity is withdrawn and the assets are sold.

Risks for Uniswap liquidity providers

The calculations above do not include fees earned by liquidity providers. However, analysts have concluded that even the amount of income from commissions does not fully cover losses from IL for almost half of Uniswap’s LPs. Here’s a quote on that, published by Cointelegraph.

The average liquidity provider in the Uniswap V3 ecosystem has suffered financially because of their choice of activity, and it would be more profitable for them to simply invest their assets. A user who chooses not to provide liquidity can expect their portfolio to grow in value at a faster rate than someone who actively deposits funds in Uniswap v3 pools.

Volume of IL in the pools monitored

Topaz Blue and Bancor Protocol experts surveyed 17 Uniswap pools, which represent 43 per cent of the platform’s total liquidity. Between 5 May and 20 September, they generated $199 million in revenue in the form of commissions for their liquidity providers. During the same time, they incurred a total of $260 million in IL.

Which means it would have been easier for capital owners here to keep the coins in their account. After all, a rise in their exchange rates would have provided more income.

Liquidity providers in 80 percent of the pools analyzed lost more on ILs than they gained commissions. Only in those pools – WBTC/USDC, AXS/WETH and FTM/WETH – the dynamics were positive. In some pools, such as MKR/ETH, losses far exceeded LP revenues.

Ratio of IL to fee income as a function of time of liquidity provision

Conclusion: in the aforementioned period, simply buying and holding coins from pools in one's wallet would have brought in more money with less risk. However, providing liquidity has its own advantages: if an investor expects that the value of the coin will not change much in the near future, the LP role can help to create a great source of passive income.

Look for even more interesting things in our millionaires cryptochat. There we will discuss other important developments affecting the blockchain and decentralisation industry.