Impermanent Loss
Impermanent loss is the difference in value between crypto in a liquidity pool and simply holding the same crypto. You can still make a profit, but it may be less than if you had done nothing.
What is impermanent loss?
A liquidity pool is a shared supply of two tokens that people can trade. When you add tokens to a pool, the proportion of your tokens changes along with their prices.
What if one token becomes much more valuable than the other? You’ll end up with relatively less of the token that rose more in value. As a result, your position may be worth less than if you had kept both tokens in your crypto wallet.
It’s called “impermanent” because the difference can disappear if the price ratio returns to the level it was at when you entered the pool. If you take your tokens out while the ratio is different, the difference becomes permanent.
An example of impermanent loss
You put equal values of ETH and USDC into a liquidity pool. Then the price of ETH rises sharply.
People buy ETH from the pool and pay with USDC. When you withdraw, you get less ETH and more USDC back. Your total value may have increased, but it could still be less than if you had simply held your ETH and USDC. That difference is impermanent loss.
Why does impermanent loss matter in crypto?
Impermanent loss is an important risk of providing liquidity in DeFi. It can happen when prices rise or fall. The more the price ratio between the two tokens changes, the larger the difference usually becomes.
That’s why, when reading about liquidity pools, yield farming, or high returns, it’s important to look beyond just the promised returns. Liquidity providers may earn some trading fees. Those fees or other rewards can sometimes offset impermanent loss, but that isn’t guaranteed.
Impermanent loss doesn’t automatically mean you lose money. It mainly means you may end up with less than you would by simply holding. This risk can be significant, especially with tokens that have large price swings.
