What is impermanent loss?

Impermanent loss is the shortfall a person can suffer by supplying tokens to a liquidity pool instead of just holding them. When the prices of the two tokens move apart, the provider's share of the pool ends up worth less than the original tokens would have been.

Why does it happen?

A liquidity pool holds two tokens and lets traders swap between them. In the standard design, a formula keeps the two sides equal in value.

When one token's price rises on the wider market, traders buy it from the pool, where it is briefly cheaper. The pool is left with less of the rising token and more of the other one. In effect, the pool sells the winner on the way up. When a token falls, the reverse happens, and the pool collects more of the loser.

A liquidity provider owns a slice of whatever the pool holds. So the provider's mix shifts toward the weaker token every time prices move.

A worked example

Suppose a provider deposits 10 tokens priced at $100 each, along with $1,000 in a dollar stablecoin. The deposit is worth $2,000. Assume this is the whole pool and ignore fees.

The token's price then rises to $400. Traders buy tokens from the pool until its price matches. Under the standard formula, the pool ends up holding 5 tokens and $2,000 in stablecoins.

• In the pool: 5 tokens at $400, plus $2,000, comes to $4,000.
• Just holding: 10 tokens at $400, plus $1,000, comes to $5,000.

The provider still made money, since $4,000 is double the starting value. But holding would have produced $1,000 more. That 20% gap is the impermanent loss.

The same gap appears if the price falls to a quarter of where it started. A doubling in price produces a gap of roughly 6%.

Why is it called impermanent?

If the token's price returns to $100, the pool drifts back to 10 tokens and $1,000, and the gap disappears. The loss exists only on paper while the funds stay in the pool.

It becomes real when the provider withdraws at the new price. Critics say the name is misleading, because prices often do not return, and many providers leave with a lasting loss.

Do fees make up for it?

Sometimes. Providers earn a share of every swap, and in a busy pool those fees can outweigh the gap. In a quiet pool, or one where a token's price runs far in one direction, they often do not.

Pools that pair two tokens meant to hold the same value, such as two dollar stablecoins, see little impermanent loss. Pools that pair a volatile new token with an established coin see the most. That matters for yield farming, where a high advertised reward can hide a loss on the underlying deposit.