What is Impermanent Loss
Impermanent loss refers to the temporary loss of funds that occurs when providing liquidity to a decentralized exchange (DEX) or automated market maker (AMM). This phenomenon arises when the price of the assets deposited in a liquidity pool diverges from their original price at the time of deposit. The term was first coined in the context of DeFi (Decentralized Finance) to describe the opportunity cost faced by liquidity providers who may have been better off simply holding their assets instead of providing liquidity.
The concept is crucial for understanding the risks involved in liquidity provision, especially in volatile markets. When liquidity providers deposit tokens into a pool, they receive liquidity tokens in return, which represent their share of the pool. If the price of the tokens changes significantly during the period they are locked in the pool, the liquidity provider may suffer a loss compared to simply holding the tokens. This loss is termed "impermanent" because it can be reversed if the prices return to their original state.
How does Impermanent Loss work?
Impermanent loss occurs when a liquidity provider deposits two assets into a pool, such as ETH and USDC, at a 50/50 ratio. If the price of ETH increases significantly after the deposit, the DEX's automated market maker will adjust the ratios of the tokens in the pool to maintain the 50/50 balance. As a result, the liquidity provider would end up with less ETH and more USDC than they initially deposited.
To quantify this, if a liquidity provider deposited 1 ETH (worth $2,000) and $2,000 in USDC, they would hold 1 ETH and $2,000 in USDC. If the price of ETH rises to $4,000, the provider might find they now hold 0.5 ETH and $4,000 in USDC instead of simply holding 1 ETH, resulting in an impermanent loss of $1,000 compared to just holding the ETH.
This loss is termed "impermanent" because if the price of ETH drops back to $2,000, the provider's assets would revert to their original value, negating the loss. However, if they withdraw their funds while the price is still above the original level, the loss becomes permanent.
