What is Impermanent Loss in DeFi?
Impermanent loss is a crucial concept in decentralized finance (DeFi) that is particularly relevant for liquidity providers in automated market makers (AMMs) like Uniswap and SushiSwap. It refers to the temporary loss of funds experienced by providing liquidity in a pool compared to simply holding the assets.
When a liquidity provider contributes assets to a liquidity pool, they are subject to price fluctuations between the assets. If the price of one asset increases significantly relative to the other, the provider's share of the pool will be worth less than if they had simply held the assets outside the pool. This discrepancy arises from the way AMMs maintain liquidity by automatically adjusting asset ratios based on trading activity.
The term "impermanent" is used because the loss can be mitigated if the prices stabilize and return to the same ratio as when the assets were deposited. However, if the provider withdraws their assets while the price difference still exists, the loss becomes permanent.
To illustrate, consider a liquidity pool with ETH and a stablecoin like USDC. If ETH's price skyrockets, the pool ratio changes, leading to impermanent loss for providers. Understanding this risk is vital for anyone considering liquidity provision in DeFi, as the potential rewards from trading fees may not always compensate for the losses incurred.