What is Impermanent Loss in DeFi?
Impermanent loss is a concept in decentralized finance (DeFi) that primarily affects liquidity providers in Automated Market Makers (AMMs). It occurs when the price of the tokens deposited into a liquidity pool diverges from their price at the time of deposit. This phenomenon can lead to a situation where the total value of the tokens left in the pool is less than what would have been earned by simply holding the assets.
The mechanics behind impermanent loss are as follows: when liquidity providers supply tokens to a pool, they receive liquidity tokens in return. These tokens represent their share of the pool. If the price of the provided tokens changes significantly, the proportion of the assets in the pool adjusts automatically to maintain the required ratios. As a result, when liquidity providers withdraw their tokens, they might receive fewer assets than they initially deposited in value terms.
This loss is termed "impermanent" because if the prices revert to their original levels, the losses can be mitigated or even completely negated. However, if the liquidity provider withdraws their assets during a period of price divergence, the loss becomes permanent. Various factors, including trading fees earned and the volatility of the assets, can impact the extent of impermanent loss. Understanding this concept is crucial for those participating in DeFi and investing in cryptocurrency.