Impermanent loss, a significant risk for liquidity providers in decentralized finance (DeFi), has cost users billions of dollars every year! Estimates suggest that losses from impermanent loss across DeFi protocols reach approximately $1 billion annually, with monthly losses running into hundreds of millions of dollars. These losses occur when the price of assets in liquidity pools diverge, impacting returns for liquidity providers.

That is why impermanent loss is a barrier to entry for many potential DeFi users. By addressing this issue, 1xMM is not only enhancing the user experience but also fostering greater adoption of DeFi protocols. Our solutions pave the way for a more resilient and inclusive financial ecosystem where users can participate confidently and profitably.

How Impermanent Loss Occurs?

Impermanent loss is indeed one of the most significant challenges faced by liquidity providers (LPs) in the decentralized finance (DeFi) ecosystem. It occurs when the value of tokens in a liquidity pool changes and LPs accumulate / decumulate these tokens , compared to simply holding the tokens individually. This phenomenon can erode the profits of LPs and dissuade users from participating in DeFi protocols, despite their potential for high rewards.

To understand impermanent loss, let’s consider an example. Imagine you deposit equal values of two tokens, Token A and Token B, into a liquidity pool. The pool facilitates trading between these tokens, and you earn a portion of the trading fees as a LP. However, if the price of Token A rises while Token B remains stable, compared to the same reference asset, the pool’s algorithm follows trade volumes to adjust token ratios and maintain a specific balance of Token A and Token B relative to change in prices (i.e. constant product principle) . Consequently, you end up holding less of Token A and more of Token B.

When you withdraw your liquidity, the total market value of your tokens in the pool might be less than if you had held them individually. This discrepancy is what we call impermanent loss. The greater the price divergence, the larger the impermanent loss. Importantly, the loss is termed “impermanent” because it could be offset if token prices revert to their original state.

Particularly in highly volatile markets, impermanent loss (IL) in DeFi liquidity pools can result in substantial financial losses for users. In some cases, IL can cause losses of up to 50% of the value of the initial deposit. For example, if a liquidity provider stakes 1 ETH worth $1500 and 1500 DAI, and ETH’s value drops by 50%, the impermanent loss could be severe, potentially outweighing the earnings from trading fees​. That is also why DeFi liquidity providers are very careful and sometimes reluctant to enter pools.

The Impact on DeFi

Impermanent loss affects both individual users and the broader DeFi ecosystem. For users, it diminishes the profitability of providing liquidity, especially during volatile market conditions. For protocols, it can reduce the overall liquidity available, making the platform less attractive to traders.

To mitigate these issues, many DeFi protocols have introduced mechanisms like liquidity mining rewards and fee structures to compensate LPs. However, these solutions often fall short of addressing the root cause of impermanent loss.

How 1xMM Addresses Impermanent Loss?

At 1xMM, we’re committed to tackling this challenge head-on through innovative staking solutions and advanced smart contract designs. Moreover, we’re integrating educational tools to help users understand the intricacies of DeFi, empowering them to make informed decisions and navigate risks effectively.

Impermanent loss typically occurs in traditional Automated Market Makers (AMMs) when the value of assets within a liquidity pool (LP) fluctuates relative to their initial deposit value. To mitigate this LP challenge, the Asagaia initiative—a global project that includes 1xMM—plans to introduce a Decentralized Order Book (DOB) framework in its next development phase.

Nevertheless, 1xMM introduces an innovative mechanism to also combat impermanent loss through its unique perpetual pools architecture, underpinned by sophisticated Futures and Options markets.

Participants stake in either long or short perpetual pools based on their market predictions. These pools allow for natural leverage, ensuring that funding rates are determined by real-time market dynamics rather than arbitrary formulas. This minimizes discrepancies that often cause impermanent losses in conventional systems.

Moreover, the design ensures that all liquidity for a specific token consolidates into a unified pool, creating an efficient system where yield generation remains consistent regardless of market volatility. This structure inherently balances the interests of stakeholders by redistributing rewards based on market performance, ensuring fairness and reducing exposure to price divergence risks.

The perpetual pools provide a clear advantage by maintaining full decentralization and ensuring that yields remain observable, reducing financial risks. In essence, 1xMM transforms traditional DeFi staking models into a sustainable, transparent, and secure system tailored to overcome impermanent loss challenges.

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