What is Impermanent Loss?

Impermanent loss is a phenomenon experienced by liquidity providers in automated market maker (AMM) protocols where the value of assets deposited into a liquidity pool becomes worth less than if those same assets had simply been held in a wallet, occurring when the prices of tokens in the pool change from their original deposit ratio.

This loss occurs because AMMs maintain constant product formulas (like x*y=k) that automatically adjust token ratios as prices change, forcing the pool to sell appreciating assets and buy depreciating ones to maintain balance, creating a divergence from the optimal strategy of simply holding assets during price movements.

The term "impermanent" can be misleading, as the loss becomes permanent if liquidity is withdrawn while prices differ from the original deposit ratio, though it may decrease or disappear entirely if prices return to their initial state before withdrawal, creating a complex risk calculation for liquidity providers.

The magnitude of impermanent loss increases with the size of price divergence between paired assets, making it particularly significant in volatile token pairs, while stable pairs (like stablecoin-to-stablecoin pools) experience minimal impermanent loss due to their price correlation, creating different risk profiles across pool types.

Liquidity providers must weigh potential impermanent loss against trading fees and incentive rewards earned from participation, with various strategies emerging to mitigate this risk including concentrated liquidity positions, dynamic fee structures, impermanent loss insurance, and single-sided liquidity provision mechanisms that aim to improve capital efficiency while reducing exposure to this unique DeFi risk.