What is Impermanent Loss?
Impermanent Loss refers to the loss caused by the fluctuation of external market prices when the liquidity provider provides liquidity (Share/LP) to the capital pool under the operating environment of Automatic Market Making (AMM). The impermanence loss only exists under AMM algorithm, and it may disappear after the asset price recovers. However, in most cases, impermanence loss is actually eternal because asset prices cannot be restored to their original positions. Thus, it is also called differential losses. To put it simple, impermanence loss is caused by the price difference between the same asset on different platforms.
After providing liquidity (Share/LP) to the capital pool, the liquidity provider obtains part of the “shares” in the capital pool. According to the OneSwap White Paper, 60% of the transaction fee income from swap and trade generated in the Pair contract will be distributed to liquidity providers.
Examples of Impermanent Loss
1) Assuming that there are 5,000 ONES and 10 ETH in ONES/ETH capital pool, the price on OneSwap is 500 ONES=1 ETH, and the external market price is also 500 ONES=1 ETH. At this time, ONES/ETH price on OneSwap is equal to the external market price, and OneSwap capital pool is balanced.
2) A liquidity provider Sam provides 500 ONES/1 ETH to the above ONES/ETH capital pool, so Sam owns 10% “shares” of ONES/ETH capital pool.
3) The external market price of ETH rises to 700 ONES=1 ETH, but the price on OneSwap is still 500 ONES=1 ETH, then arbitrage space is generated.
4) An arbitrageur Jan buys 1 ETH from the OneSwap capital pool at a price of 500 ONES. As a result, the remaining capital pool is 5500 ONES and 9 ETH, and ONES/ETH capital pool is out of balance. ETH reserves falls and the price of ETH in this capital pool rises, and the arbitrage space continues to exist until the price of ETH in OneSwap rises to 700 ONES, which is the same as the external market price.
5) At this time, the liquidity provider Sam removes his liquidity from the pool of 5500 ONES/9 ETH. Sam actually withdraws 10% of both 5500 ONES and 9 ETH, that is 550 ONES and 0.9ETH. Thus, Sam’s asset value at this time is 0.9*700+550=1180 ONES.
6) Calculated based on the value when Sam added liquidity initially. At that time, Sam invested 500 ONES/1 ETH, and the initial asset value should be 1*700+500=1200 ONES. As a liquidity provider, Sam bear 20 ONES impermanent loss in this process.
Note: In order to facilitate the calculation of the above process, slippage and transaction fees are ignored.