Disappearing DeFi rewards: Understanding impermanent loss in crypto

Why let cryptocurrency sit in a wallet for months or years when it could generate consistent passive income? With dozens of decentralized finance (DeFi) apps, crypto holders can do just that by capitalizing on passive yields from DeFi protocols. These platforms allow users to lend, stake, or provide liquidity in exchange for rewards, turning idle assets into active earners.

While DeFi offers attractive rewards for lenders, it also exposes them to "impermanent loss," which can diminish potential returns.

Before depositing digital assets into DeFi, it’s important to understand how impermanent loss can impact rewards and carefully weigh the potential gains against the risks.

In this guide, we'll tell you what you need to know.

What is impermanent loss in crypto?

In DeFi, the term “impermanent loss” refers to when the value of an investor’s deposited cryptocurrencies decreases relative to simply holding those assets in a wallet. This phenomenon is specific to DeFi applications that use liquidity pools.

A liquidity pool is a protocol within a DeFi application that relies on algorithms and automated commands, known as smart contracts, to rebalance funds deposited by crypto investors (called liquidity providers). These pools enable intermediary-free trading by drawing on funds contributed by the crypto community. Anyone with compatible digital assets and a crypto wallet can deposit assets into a liquidity pool and earn rewards for their participation.

When there are changes in a pool’s composition or the market prices for crypto assets, the pool automatically rebalances everyone’s positions to maintain a constant balance (typically 50/50). These constant adjustments often lead to a potential loss in value compared to holding cryptocurrencies in a private wallet. 

Example of impermanent loss

Imagine a trader deposits Ethereum (ETH) and the stablecoin USD Coin (USDC) into a liquidity pool on a decentralized exchange (DEX) like Uniswap. A few weeks later, ETH’s price doubled, prompting the pool’s algorithm to increase the supply of USDC relative to ETH to maintain the 50/50 balance. When the trader withdraws their assets, they find they have less ETH than originally deposited. While the ETH they withdraw is more valuable due to the price increase, they would have retained more ETH overall by not participating in the liquidity pool.

How does liquidity pool impermanent loss happen?

Impermanent loss occurs in liquidity pools due to the automated market maker (AMM) model, a rebalancing mechanism used by DeFi protocols. First introduced by the decentralized exchange (DEX) Uniswap, AMMs rely on the formula x * y = k to maintain balance in the pool. In this formula, “x” and “y” represent the quantities of the two assets in the pool, while “k” is a constant.

When the price of one token in a liquidity pool changes relative to the other, the AMM rebalances the pool by adjusting the token quantities. As a result, liquidity providers end up holding less of the more valuable token. Arbitrage traders often exploit these price differences by buying the underpriced token in the pool and selling it on the open market, further amplifying the token imbalance. The resulting difference in value between the rebalanced tokens and the original tokens held outside the pool illustrates impermanent loss.

However, impermanent loss is not always certain. Losses only materialize if liquidity providers withdraw their funds before token prices return to their original levels. Additionally, rewards earned from providing liquidity can often offset the effects of impermanent loss. The longer liquidity providers contribute to a pool, the more rewards they accumulate, making it harder for impermanent loss to outweigh the benefits.

Impermanent loss calculator: How to determine impermanent loss 

To calculate impermanent loss, start by determining the total value of the crypto that was initially deposited into the liquidity pool. This will be the baseline for comparing against your current holdings as market prices fluctuate.

Then, use the following formula – a simplified variation of the standard, more complex formula – to get an approximate estimate of how much value has been lost compared to holding the original assets in a wallet:

Impermanent loss = (Pool Balance Value / Hold Value - 1) * 100%

Let’s look at a specific example: Suppose a trader deposits 1 ETH (valued at $1,000) and 1,000 DAI into a liquidity pool with a 50/50 ratio. The initial deposit value equals $2,000.  

If ETH’s price doubles to $2,000, the ETH-to-DAI ratio in the pool shifts to 2:1 instead of the original 1:1. The AMM algorithm rebalances the pool, adjusting the amount of ETH relative to DAI to maintain equilibrium in the **x * y = k** formula.  

For simplicity, assume the trader’s share in the pool is now 0.7 ETH and 1,414 DAI, worth $2,814 in total. By comparison, if the trader had simply held 1 ETH and 1,000 DAI, the combined value would be $3,000.  

Using the impermanent loss formula:  

($2,814 / $3,000 - 1) * 100% = 6.2% 

This calculation shows a 6.2% impermanent loss due to participating in the liquidity pool rather than holding the assets outright.  

As long as liquidity providers know their current share in the pool, they can use this formula to calculate impermanent loss. However, tools like impermanent loss calculators on platforms like CoinGecko simplify the process, allowing users to input values and model different price changes.

It’s important to remember that impermanent loss calculations don’t account for rewards earned from providing liquidity. For a complete picture of how much crypto was “lost,” add the value of their earned rewards to their current pool holdings when assessing their net gains or losses.

Are there tax implications for impermanent loss? 

Tax policies for DeFi activities, including liquidity pools, vary by country, but impermanent loss itself typically doesn’t trigger direct tax implications. Most tax authorities do not levy taxes on unrealized gains or losses from cryptocurrencies. However, if traders withdraw their share of a liquidity pool and the value of their tokens decreases due to impermanent loss, this affects their overall profit and loss calculations.

The key taxable events in liquidity pool participation include swapping assets, entering or exiting a pool, and receiving or exchanging liquidity pool (LP) tokens or governance token rewards. Establishing an entry price is critical for calculating a cost basis and determining gains or losses.

Given the complexities of DeFi taxation, consulting a crypto-savvy CPA is highly recommended. Tools like CoinTracker’s Portfolio Tracker can simplify record-keeping by tracking DeFi activity, including liquidity pool participation, to ensure accurate and compliant tax filings.

Ways to minimize impermanent loss in liquidity pools

Impermanent loss is an inherent risk when contributing to liquidity pools, but there are strategies to reduce its impact. Understanding these methods helps traders gauge their risk tolerance when depositing digital assets.

Diversify across liquidity pools

Using different token pairs in various liquidity pools helps spread risk and manage the expected volatility in a crypto portfolio. By avoiding concentration in any one pool, traders enhance their resilience to market fluctuations for better odds of long-term profitability.

Implement dynamic range management

Dynamic range management involves adjusting a liquidity position to a specific price range, reducing exposure to price swings outside that band. Concentrating liquidity within this targeted range minimizes impermanent loss and is particularly useful for volatile token pairs. This strategy allows liquidity providers to earn high rewards while limiting risk.

Use stablecoins or correlated pair pools

Stablecoins have a fixed ratio with an underlying asset, so they maintain an equal value in a liquidity pool and eliminate the risk of impermanent loss. Similarly, correlated digital assets like Ethereum and Staked Ether (stETH) mirror each other’s prices, providing another way to minimize impermanent loss in liquidity pools.

Monitor positions using DeFi tools

Proactively tracking liquidity pool performance helps traders respond to changing market conditions. DeFi dashboards and portfolio trackers provide real-time insights, including pool ratios, asset prices, and accrued fees. These tools enable traders to evaluate their positions objectively and make adjustments to limit impermanent loss risks.

Balance your crypto rewards and risks with a CoinTracker account

If you participate in DeFi activities like liquidity pools, liquid staking, or crypto loans, remember that these count as taxable events in many countries. However, crypto taxes for passive income strategies aren’t the same as capital gains for selling crypto. One easy way to differentiate these activities in your tax reports is CoinTracker. Our Portfolio Tracker seamlessly logs every transaction from exchange accounts, wallets, and DeFi applications, ensuring accurate and compliant IRS reports. 

See why millions of crypto investors trust CoinTracker to handle their tax data with ease and precision. 

Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.