Clear DefinitionsImpermanent Loss
2 min read
Pronunciation
[ɪm-ˈpɜr-mə-nənt lɔs]
Analogy
Think of impermanent loss as the cost of being a shopkeeper instead of a collector. If you own 10 gold coins and 1000 silver coins, and gold's value suddenly doubles, as a collector you'd enjoy the full appreciation. But if you're running a gold/silver exchange shop (like an AMM pool) that must always balance supply and demand, your inventory would automatically adjust to about 7 gold coins and 1400 silver coins—still valuable, but worth less than your original collection would be now.
Definition
The temporary reduction in value that liquidity providers experience when contributing assets to automated market maker (AMM) pools compared to simply holding those assets. Impermanent loss occurs when the price ratio of paired assets changes after deposit, forcing the AMM to automatically rebalance the pool, resulting in a different composition than initially provided.
Key Points Intro
Impermanent loss has several key characteristics that affect liquidity provision strategies.
Key Points
Volatility correlation: Greater price divergence between paired assets leads to larger impermanent losses.
Reversibility: The loss becomes "permanent" only when liquidity is withdrawn; if prices return to the original ratio, the loss disappears.
Fee offset: Trading fees earned by liquidity providers can potentially compensate for impermanent loss over time.
Pool design impact: Different AMM formulas and concentrated liquidity mechanisms can mitigate or exacerbate impermanent loss.
Example
Alice deposits $10,000 worth of assets into an ETH/USDC 50/50 pool when ETH is priced at $2,000 (so she deposits 2.5 ETH and 5,000 USDC). A month later, ETH price doubles to $4,000. If she had simply held her assets, she would have 2.5 ETH ($10,000) and 5,000 USDC ($5,000) for a total of $15,000. However, due to the AMM's constant product formula, her pool position now contains approximately 1.77 ETH and 7,071 USDC, worth $14,142—creating an impermanent loss of about $858 or 5.7% compared to holding.
Technical Deep Dive
Impermanent loss is mathematically derived from the constant product formula (x * y = k) used by many AMMs like Uniswap V2. When asset prices change, arbitrageurs trade against the pool until its ratio matches the external market price, altering the composition of the pool's reserves. The magnitude of impermanent loss (IL) can be calculated using the formula: IL = 2√(price ratio) / (1 + price ratio) - 1, where price ratio is the new price divided by the initial price. This formula shows that impermanent loss: 1) is always negative or zero, 2) increases with price divergence but at a decreasing rate, 3) is symmetrical whether prices increase or decrease by the same factor, and 4) approaches 100% as one asset's price approaches infinity, converging to a maximum loss of -100%.
Security Warning
Beware of pools with highly volatile or correlated assets as they can experience severe impermanent loss during market turbulence. Some malicious projects intentionally create pools with manipulated tokens to exploit liquidity providers through forced impermanent loss.
Caveat
While often described as "impermanent," these losses frequently become permanent as asset prices rarely return to exact initial ratios. Trading fees must significantly outpace impermanent loss to make liquidity provision profitable, which is not guaranteed in low-volume or highly volatile pairs. Advanced AMM designs like Uniswap V3's concentrated liquidity can reduce impermanent loss but introduce additional complexity and active management requirements.
Impermanent Loss - Related Articles
No related articles for this term.