Impermanent Loss

Impermanent loss describes the temporary loss of funds occasionally experienced by liquidity providers because of volatility in a trading pair.

This also illustrates how much more money someone would have had if they simply held onto their assets instead of providing liquidity.

Liquidity pools often feature two assets — and while one might be a stablecoin such as DAI, the other could be a more volatile cryptocurrency such as ETH.

Let’s imagine that a provider needs to offer equal levels of liquidity in both DAI and ETH — but suddenly, the price of ETH goes up.

This creates an irresistible opportunity for arbitrage, because the price of ETH in the liquidity pool now doesn’t reflect what’s going on in the real world. To ensure the ratio of DAI to ETH remains balanced, other traders will buy ETH at a discounted rate until there’s equilibrium again.

After arbitrage, a liquidity provider may end up with a greater amount of DAI and slightly less ETH. Impairment loss assesses the current value of their assets against what they would be worth if left sitting pretty in an exchange.

The loss only becomes permanent if a provider decides to withdraw their liquidity for good.