tl;dr: Providing liquidity to a decentralized exchange has its risks. One way to calculate them.

One of the exciting innovations of the Decentralized Finance (DeFi) world is the opportunity for individuals and institutions to put their capital to work in a more efficient way by contributing it as liquidity to help facilitate trades of pairs of tokens without having too much slippage in the price.

In return for doing so, the providers of the liquidity on places like Uniswap, Sushiswap, Balancer, and others earn a share of the fees associated with the trades.

Instead of all of the commissions going to the centralized broker/exchange, in essence the commissions get split among those tokens that form the liquidity pool.

This sounds great and it can be, but like everything, there’s a potential downside.

One of the downsides is that the liquidity provider takes on a risk known as “Impermanent Loss.”

What this means, as I understand it, is that if you provide liquidity to a pool supporting a token pair at a certain moment in time, the value of your total holdings may fall because of changes in the greater market surrounding the two tokens.

So, for example, let’s say you put $1000 worth of Ether and $1000 worth of Balancer in a pool. That $1000 worth of each is calculated based on today’s prices of both Ether and Balancer. However, what if Ether goes down? What if Balancer goes down? What happens to you if you want to get your tokens out and how is that different that if you had just held on to them?

There’s a lot of math here and it’s all based on something called, at least in Uniswap, the “constant product formula.”

The point is, there are moments where, if you were to pull your tokens out of the Liquidity Pool (ignoring the gas fees for a moment), you may end up with fewer tokens of one or both.

This can get tough to track, but the good news is that there’s now an “Impermanent Loss Calculator” tool which can help you.

It may be worth it to go in and pick two of your favorite tokens and run some simulations yourself so you can see what happens as prices changes and how it might impact your total holdings.

It’s a new world, DeFi, and “Impermanent Loss” is here to stay so, I guess that’s permanent, which is why getting familiar with the machinations of this new model is worth a few minutes of time.