Impermanent Loss

On decentralized exchanges such as Uniswap, users deposit pairs of tokens into liquidity pools to facilitate trading, in return for a share of transaction fees. The ratio of the tokens in these pairs determines their prices. When token prices fluctuate, the automated market maker (AMM) smart contract automatically rebalances the pool's token holdings through trading activity, changing the proportions of each asset held by liquidity providers. This can result in a difference between the value of providing liquidity versus simply holding the same tokens in a wallet.

For example, imagine depositing $100 of ETH and $100 of USDC into a standard 50/50 liquidity pool. If ETH doubles in price, the pool’s token balances shift as traders buy ETH. This leaves the pool holding less ETH and more USDC, meaning liquidity providers effectively miss out on some of ETH's price appreciation. These missed gains are known as impermanent loss.

The larger the relative price movement between the two assets, the greater the potential loss. Liquidity providers can reduce this risk by choosing pairs with relatively stable prices, such as two dollar-pegged stablecoins. In some cases, trading fees and liquidity incentives are already sufficient to compensate for any missed price appreciation.

The term “impermanent” reflects the possibility that the loss could disappear if the tokens return to their original relative prices before liquidity is withdrawn. Importantly, impermanent loss does not necessarily mean losing money outright: a liquidity position can increase in dollar value while still underperforming a strategy of simply holding the original assets.