Impermanent Loss
risk type
Impermanent Loss refers to the temporary reduction in value a liquidity provider (LP) may suffer when contributing assets to a liquidity pool, especially when the prices of those assets diverge significantly. This occurs because AMMs automatically rebalance token ratios, and LPs may end up withdrawing more of the depreciated asset and less of the appreciated one. The loss becomes permanent only if the funds are withdrawn before price convergence.
Use Case: An LP deposits $ETH and $FLR into a pool. If $ETH triples in value while $FLR stays flat, the AMM sells some $ETH to maintain a 50/50 ratio. When the LP exits, they receive more $FLR and less $ETH—resulting in a realized loss compared to holding both tokens separately.
Key Concepts:
- Price Divergence — When paired tokens shift in value relative to each other.
- LP Rebalancing — Automated adjustments by AMMs to maintain pool ratios.
- IL Curve — A visual representation of loss severity based on divergence.
- Realized Loss — When impermanent loss becomes permanent upon withdrawal.
Summary: Impermanent loss is a fundamental risk in liquidity provisioning. While trading fees and incentives may offset the loss, LPs in volatile pools can still suffer significant value erosion. Smart timing, stable pairs, and protocol design can help reduce exposure.