Impermanent loss is a risk that affects liquidity providers in decentralized finance (DeFi) protocols. It occurs when the price of tokens you deposited into a liquidity pool changes relative to when you deposited them, resulting in less value than if you had simply held the tokens in your wallet.
Here is how it works: when you provide liquidity to an AMM pool, you deposit two tokens in equal value. As traders swap between these tokens, the ratio in the pool shifts. If one token rises significantly in price, the pool rebalances and you end up with more of the cheaper token and less of the expensive one.
The loss is called impermanent because it only becomes permanent when you withdraw your funds. If the prices return to their original ratio, the loss disappears. However, in practice, prices rarely return to exactly the same levels.
Key factors that influence impermanent loss:
- Price divergence — the greater the price change between the two tokens, the larger the loss
- Pool type — stablecoin pairs experience minimal impermanent loss since their prices stay close together
- Trading fees — fees earned from the pool can offset impermanent loss over time
To manage this risk, many yield farmers choose pools with correlated assets or pools that offer high enough trading fees and rewards to compensate for potential losses. Always calculate your expected returns versus impermanent loss risk before committing funds.