In this article we'll go over:

• What is Impermanent Loss

• Impact of Impermanent Loss

• Examples of Impermanent Loss

• Mitigating Impermanent Loss

Let's dive in!

What is Impermanent Loss

Impermanent loss refers to a temporary loss incurred by liquidity providers (LPs) in automated market maker (AMM) protocols when the price of the deposited assets changes relative to the time of deposit.

Impact of Impermanent Loss

Impermanent loss is primarily experienced when the price of one asset in the pool significantly deviates from its initial value. The greater the price divergence, the more pronounced the loss. Let's look at a few examples.

Examples of Impermanent Loss

Example 1 : ETH-USDT Pair

Suppose you deposit 10 ETH and 10,000 USDT into an AMM pool with an initial price of 1 ETH = 1,000 USDT. After some time, the price of ETH rises to 1 ETH = 2,000 USDT. As a result, the value of the deposited ETH increases to 20,000 USDT.

Due to the automated rebalancing mechanism, the pool's value adjusts to reflect the new price, resulting in an imbalance between the deposited assets. This temporary loss experienced is impermanent loss.

Example 2: ETH-ARB Pair, two volatile currencies

Say you deposit 5 ETH and 10,000 ARB into the AMM pool, with an initial price of 1 ETH = 2,000 ARB. Later on, the price of ETH drops to 1 ETH = 1,500 ARB. Consequently, the value of the deposited ETH decreases to 7,500 ARB.

Again, the pool rebalances, and the temporary loss incurred is impermanent loss. Liquidity providers face this risk as they aim to provide liquidity to various trading pairs and earn fees.

Mitigating Impermanent Loss

There are several strategies can help mitigate impermanent loss. One approach is to carefully select the pairs you provide liquidity for, focusing on assets with less volatility or those you believe will experience price stability.

Impermanent loss is an inherent risk for liquidity providers in AMM protocols. Understanding its mechanisms is crucial for making informed decisions. So do your portfolio a favor and consider the dynamics of asset prices and market conditions before adding to a liquidity pool.