What is it?
Impermanent Loss (IL) is the difference in value that a Liquidity Provider (LP) experiences by holding their tokens in an Automated Market Maker (AMM) liquidity pool compared to if they simply held these tokens in their wallet (HODL).
Simply put, this is a loss caused by the change in the price of tokens in the pool relative to the price when they were deposited. This loss is called "impermanent" because it disappears if the price of the tokens returns to the initial level.
How does it work?
IL arises because AMM maintains a constant ratio of the pool's value (for example, X \cdot Y = K). When the price of one asset increases:
Arbitrage: Arbitrage traders buy an undervalued asset from the pool and sell an overvalued one until the pool price aligns with the market.
Selling a More Expensive Asset: Essentially, LP sells part of their asset that has appreciated in value for an asset that has appreciated less or remained stable to maintain the balance of the pool.
Loss: Ultimately, when LP withdraws their funds, they receive fewer tokens that have appreciated in value than if they had simply held them, and a greater number of more stable (or less appreciating) tokens.
Example: You invested 1 ETH (price $3000) and 3000 USDC. Total value $6000. If the price of ETH rises to $6000, AMM will force you to hold approximately 0.707 ETH and 4242 USDC. Total value $8484. If you had held 1 ETH and 3000 USDC, the value would have been $9000. The difference ($9000 - $8484 = $516) is the Impermanent Loss.
Why is IL a key trend?
IL is a fundamental risk for all Liquidity Providers (LP) in the AMM model. The success of LP depends on whether they can earn enough trading fees to offset this Impermanent Loss.
Design of Tokenomics: New protocols are actively developing mechanisms (such as Concentrated Liquidity or single-sided pools) to minimize IL.
Risk Management: Understanding IL is critical for any investor participating in Yield Farming.
Impermanent Loss is a central concept that distinguishes AMM trading from traditional exchange trading and requires a deep understanding of DeFi risks.
👉 Want to know more? Subscribe, because it will get even more interesting on our shared journey to knowledge in the Web3 world!
🤔 Did you understand and remember today's crypto term? Then don't hesitate, take the test in this post. Answer correctly, and you'll receive crypto as a gift 🎁
