Uniswap V3: Impermanent Loss

This article covers the concept of impermanent loss and the role it plays in Uniswap V3

Although impermanent loss is not new to Uniswap, it is important to consider alongside V3 and concentrated liquidity. Impermanent loss occurs when LPs miss out on the price appreciation of an asset because they are providing liquidity. As the relative price of one asset increases over another, it is being swapped out for the other asset in the trading pair.

For example, in a ETH-USDC pool, if users are putting in USDC and taking out ETH, then the LP is getting more USDC and losing ETH at the same time as ETH’s price is rising. In V2 and earlier versions, this wasn’t as big of an issue since LPs were providing liquidity for the entire range from zero to infinity. This means that impermanent loss was never totally complete. The LP would still hold some of the asset that was experiencing price appreciation even if the price approached the lower or upper bounds of the price curve. Although they still hold some of the underlying asset, there is still the risk to LPs that they would’ve been better off just holding the underlying asset and not providing liquidity.

Concentrated liquidity in V3 causes impermanent loss to be more pronounced. In V3, if there is a price swing above or below your upper or lower price limit then you are left holding all of one asset, specifically the asset that is experiencing the decline in price. Once this happens, two things are working against you. First, you have the opportunity cost of simply holding the underlying asset that experienced the price increase. Second, you will no longer be earning fees because you will not be providing liquidity. Although the risk of impermanent loss can be higher in V3 than in V2, capital is also much more efficient in V3 meaning that you can use less of your capital to earn the same amount of fees. In this way, you can properly manage your capital to ensure you have a similar risk profile.