What is Impermanent Loss?

Impermanent loss occurs when a liquidity provider's (LP) assets in an Automated Market Maker (AMM) lose value compared to simply holding them in a wallet. This happens because the AMM must rebalance its pool when the market prices of the tokens change.

How does Impermanent Loss work?

An LP deposits equal values of two tokens (e.g., ETH and USDC) into a pool.
The AMM uses a constant product formula to maintain balance: x * y = k
If the external price of ETH rises, arbitrageurs buy ETH from the pool at a discount.
The pool now contains less ETH and more USDC than the LP originally deposited.
If the LP withdraws now, the total value is lower than if they had just held the tokens.

Why does Impermanent Loss matter?

Impermanent loss is the primary risk for anyone providing liquidity in DeFi. To be profitable, the trading fees and "yield" earned from the pool must be higher than the amount lost due to price divergence.

Key features of Impermanent Loss

Inherent risk of AMM liquidity pools
Scales with the volatility of the token pair
Most extreme when one asset "moons" or "crashes" relative to the other
Offset by transaction fees and liquidity incentives
"Impermanent" until the point of withdrawal

Examples of Impermanent Loss

If you provide liquidity to an ETH/DAI pool and the price of ETH doubles, you will have less ETH and more DAI upon withdrawal, resulting in a lower total value than if you had just kept your original ETH and DAI in your wallet.