Divergence Loss in Web3

June 22, 2022

What is Divergence Loss?

Divergence loss (often called impermanent loss) is loss in funds that occurs while providing liquidity when the coins in the liquidity pool diverge in price. It’s normal (even inevitable) while providing liquidity and is usually made up for by yields, except when the price change is very large. It can be viewed as the price paid by investors for the chance to earn high yields. 

Why Does It Happen?

Liquidity pools require an equal value of two coins to be held together. When the price of one of the coins changes the amount of the second coin will adjust to maintain the same total value in the pool. This happens naturally from market forces.  

Liquidity pools themselves exist within a broader market of other liquidity pools. If one coin is cheaper in your pool vs. the broader market, opportunistic traders called arbitrageurs will buy the cheap coin from your pool in order to sell it in an alternate pool. This buying will cause the price within your pool to adjust until it matches the broader market. The resulting shift in the balance of coins in your pool and the small profits these arbitrageurs make cause divergence loss. 

How Bad is Divergence Loss?

Divergence loss is insignificant except when there are very large moves in a coin's price and is usually made up for by the annual yield

The table below illustrates the effects of divergence loss vs. holding a coin pair assuming you held for a year:

Comparison table for holding vs. providing liquidity

As can be seen, as long as the yield is high enough you’ll always profit from holding in the pool except during very extreme price movements. 

One way to view impermanent loss is that it’s essentially the price liquidity providers pay to get the annual yield associated with yield farming. It’s not bad or scary, it’s just a necessary part of how it works. 

What Questions Do You Have?

Did we miss anything in the explanation? Please reach out and let us know!