Impermanent Loss

What is Impermanent Loss?

Impermanent Loss refers to the temporary loss of funds experienced by providers (LPs) in a , primarily in (DeFi) platforms. This loss occurs when the price of the assets in the pool changes compared to when they were originally deposited. The loss is “impermanent” because it can be reversed if the prices return to their original state.

Key Characteristics

  1. Price Divergence: Occurs when the prices of assets in a liquidity pool diverge significantly from their initial deposit prices.
  2. Reversible Loss: Can be mitigated if prices revert to their initial ratio.
  3. Associated with (AMMs): Common in pools governed by AMMs, where assets are traded based on a mathematical formula.

How It Happens

  • Asset Value Changes: As the value of one asset in a pair increases or decreases, the pool’s ratio of assets adjusts to maintain a constant value.
  • Arbitrage Trading: Traders capitalize on price differences, further altering the pool’s composition and contributing to impermanent loss for LPs.

Example Scenario

  • A deposits equal values of two tokens, A and B, in a pool.
  • If the price of A increases in the market, arbitrage traders will buy cheap A in the pool and sell expensive A in the market.
  • This process changes the ratio of A to B in the pool, leading to a different distribution of tokens when the LP withdraws them compared to the initial deposit.

Mitigation Strategies

  • Diversification: Participating in multiple pools to spread risk.
  • Stablecoin Pools: Using pools with less volatile assets, like , to reduce potential impermanent loss.

Impermanent Loss is an important consideration for anyone looking to provide liquidity in DeFi platforms, as it represents a unique risk inherent in the AMM model.