What Is Impermanent Loss?

The simple definition is followed by the more specifically crypto definition.

Imagine you have two kinds of candy: chocolates and gummy bears. You decide to put them in a big candy jar at your school so other kids can trade candies. To start, you put in 10 chocolates and 10 gummy bears, and they’re both worth the same (1 chocolate = 1 gummy bear).

Now, as kids trade, the value of chocolates goes up—maybe they become super popular! Suddenly, 1 chocolate is worth 2 gummy bears. The jar adjusts, so now there are fewer chocolates and more gummy bears in the jar to match the new trade values.

When you go to take your candy back out, you end up with fewer chocolates and more gummy bears than you started with. If you had just kept your candies instead of putting them in the jar, they’d be worth more now because chocolates got so popular. That’s the impermanent loss—you “lost” value because of the price change while your candy was in the jar.

But if chocolates and gummy bears go back to being equal again, the loss might go away, which is why it’s called impermanent!

An impermanent loss occurs when you provide liquidity to a decentralized finance (DeFi) pool (e.g., in Uniswap or SushiSwap), and the value of the tokens you deposited changes compared to when you deposited them. It’s called “impermanent” because the loss is only realized if you withdraw your tokens before the price rebalances or stabilizes.

How It Happens:

When you provide liquidity, you typically deposit two tokens of equal value (e.g., ETH and USDT) into a liquidity pool. The pool uses an automated market maker (AMM) model to facilitate trading, adjusting the ratio of the tokens in the pool as their prices fluctuate.

Here’s where impermanent loss kicks in:

  1. If one token’s price increases (or decreases) significantly compared to the other, the pool’s algorithm rebalances the ratio of the tokens.
  2. As a result, you might end up with more of the less valuable token and less of the more valuable one.
  3. When you withdraw your liquidity, the total value of your tokens may be less than if you had simply held them outside the pool.

Example:

  1. You deposit 1 ETH (worth $1,000) and 1,000 USDT into a liquidity pool.
  2. The price of ETH doubles to $2,000 while USDT remains $1.
  3. The pool adjusts its ratio of ETH to USDT to maintain its pricing model, so you now own 0.707 ETH and 1,414 USDT (totaling $2,828).
  4. If you had simply held your original tokens (1 ETH and 1,000 USDT), their value would now be $3,000.
  5. Your impermanent loss is $172 ($3,000 – $2,828).

Why It’s Called “Impermanent”:

If the prices of the tokens in the pool return to their original levels, the loss disappears. However, if you withdraw your funds while the price imbalance exists, the loss becomes permanent.

How to Mitigate It:

  1. Stick to Stablecoin Pools: Pools with assets that have similar values (e.g., USDC/USDT) experience minimal impermanent loss.
  2. Diversify Across Pools: Spreading liquidity reduces exposure to any single token’s price fluctuations.
  3. Yield Farming Rewards: Many platforms incentivize liquidity providers with rewards (like tokens), which can offset potential losses.

In short, impermanent loss is the risk you take in exchange for earning transaction fees or other rewards as a liquidity provider. Understanding it is key before diving into DeFi!