What is Impermanent Loss?
Impermanent loss is a phenomenon that occurs in decentralized finance (DeFi) when providing liquidity to automated market makers (AMMs). It arises when the price of the deposited assets changes relative to their prices at the time of deposit.
When liquidity providers (LPs) deposit tokens into a liquidity pool, they are effectively offering their assets for trading. If the price of the assets diverges significantly from their initial value during the time they are locked in the pool, LPs may experience a reduction in the overall value of their holdings compared to simply holding the tokens in a wallet.
This loss is termed "impermanent" because it only becomes permanent if the LP withdraws their tokens while the prices remain diverged. If prices return to their original levels, the LP may recover their previous value. Additionally, impermanent loss can be offset by the trading fees earned from liquidity provision, making careful assessment essential for potential liquidity providers.
Understanding impermanent loss is crucial for those participating in DeFi, as it affects decision-making regarding liquidity provision and risk management strategies. It highlights the trade-offs inherent in decentralized trading protocols.