Impermanent Loss

Understanding Impermanent Loss

Impermanent loss is the term used to describe the temporary loss of funds that liquidity providers may encounter as a result of volatility in a trading pair.

This concept emphasizes the missed opportunity for liquidity providers who could have earned more by simply holding onto their assets instead of providing liquidity.

In most cases, liquidity pools are made up of two different assets, with one being a stablecoin like DAI and the other being a more volatile cryptocurrency like ETH.

Let’s consider a scenario where a liquidity provider needs to maintain equal levels of liquidity in both DAI and ETH. However, suddenly the price of ETH rises.

This situation presents an attractive opportunity for arbitrage, as the price of ETH in the liquidity pool does not accurately reflect its real-world value. To restore the balance between DAI and ETH, other traders will purchase ETH at a discounted rate until equilibrium is reached.

As a result of this arbitrage, a liquidity provider may end up with a higher amount of DAI and a slightly lower amount of ETH. Impermanent loss assesses the current value of their assets compared to what they would have been worth if they had remained untouched in an exchange.

It is important to note that this loss only becomes permanent if a liquidity provider decides to permanently withdraw their liquidity.