What is Impermanent Loss?
Impermanent loss refers to the temporary loss incurred by liquidity providers (LPs) in an Automated Market Maker (AMM) environment due to market price fluctuations. When prices rise or fall, the value of assets obtained after withdrawing liquidity may be lower than the value of simply holding the assets. This loss occurs because of the constant product pricing mechanism of AMM. As prices revert, impermanent loss will gradually diminish.
Example of Impermanent Loss
- Assume a liquidity pool contains 1,000 POL and 500 USDT, with a constant product of 1,000 * 500 = 500,000. Liquidity provider Lares holds 10% of the POL/USDT pool, or 100 POL and 50 USDT, where 1 POL = 0.5 USDT.
- Over time, the price of POL increases, changing the asset ratio to 500 POL and 1,000 USDT. The constant product (500 * 1,000 = 500,000) remains unchanged, and 1 POL = 2 USDT. Lares' share changes to 50 POL and 100 USDT.
- If Lares withdraws liquidity, they will receive 50 POL and 100 USDT, valued at 50 * 2 + 100 = 200 USDT.
- If Lares had held 100 POL and 50 USDT without providing liquidity, their assets would now be worth 100 * 2 + 50 = 250 USDT. The difference (50 USDT) represents impermanent loss.
Note: Transaction fees are excluded for simplicity.
How to Mitigate?
Impermanent loss is common in early market-making or one-sided market trends. It can be mitigated over time as transaction fees accumulate and prices stabilize, eventually leading to realized market-making profits.