Understanding the concept of impermanent loss is essential when contemplating providing liquidity on AMM type decentralized exchanges like Uniswap and PancakeSwap. Here’s a quick breakdown of the AMM mechanism from a liquidity provider’s perspective;
When someone is trading on AMMs like Uniswap and PancakeSwap, they are buying and selling tokens against the liquidity that you and others have provided. This means that if you for example deposit 100k SOUL and 15 ETH as liquidity for the pool, those who buy SOUL will buy some of your SOUL, and those who sell SOUL will receive a part of your ETH (while you receive their SOUL/ETH in return). This means that the liquidity pool’s balances of the two tokens in the trading pair will change depending on whether there’s a net buy pressure or a net sell pressure.
So effectively those 100k SOUL and 15 ETH you deposited to the pool can turn into 150k SOUL and 10 ETH or 50k SOUL and 30 ETH (these are examples, not exact math – particularly because Uniswap V3’s concentrated liquidity principle allows liquidity providers to define their own ranges to provide liquidity in).
Essentially, providing liquidity in an AMM pool is like placing granularly laddered buy and sell orders on a centralized exchange. If there’s a net price increase of the token compared to what it’s trading against (ETH on Uniswap), you are accepting that you will gradually sell some SOUL as the price increases. However it’s also a way to automatically DCA (dollar cost average), as you will gradually be buying SOUL for ETH if the price decreases (net sell pressure)
The changes in your balances that occur as a result of the net buy/sell pressure is what’s referred to as impermanent loss – which is a misleading term, but good enough. Impermanent loss is the difference in value between what you have in the liquidity pool at any given moment compared to the value of your original deposit if you had simply left them in your wallet instead of providing liquidity.
To offset the risk of impermanent loss you earn a share of the trading fees on all AMMs like Uniswap and PancakeSwap. Though this is usually not sufficient incentive for people to accept the IL risk. This is the reason why various projects offer additional incentives for token holders to provide liquidity. Phantasma Pharming is such an incentivization protocol, which boosts the APY and significantly offsets the IL risk up to a large total pool size.
Individual reasons for providing liquidity can vary. Some provide liquidity to earn rewards in various forms (trading fees, Pharming rewards). For others, the main reason for providing liquidity with a percentage of their holdings can be the view that better liquidity makes the pool all the more attractive to traders, which in turn can increase the trading volume.