Impermanent Loss

Impermanent Loss occurs in liquidity providing mechanisms, such as Automated Market Makers (AMMs), when the value of the assets in the liquidity pool diverges significantly from the value of those same assets held individually. It arises due to the dynamic nature of liquidity pools, where the prices of the assets change over time.

Example:

Let's consider a liquidity provider who deposits equal amounts of two assets, A and B, into a liquidity pool on a decentralized exchange (DEX). At the time of deposit, 1 token of A is worth $10, and 1 token of B is worth $10 as well.

The liquidity provider deposits 10 tokens of A and 10 tokens of B, worth a total of $200.

Now, suppose the price of token A increases to $15, while the price of token B remains unchanged at $10.

The liquidity pool now holds 10 tokens of A ($150 value) and 10 tokens of B ($100 value). The total value of the pool is now $250.

If the liquidity provider decides to withdraw their liquidity at this point, they would receive 10 tokens of A ($150) and 10 tokens of B ($100), totaling $250.

However, if the liquidity provider had simply held onto their tokens instead of providing liquidity, they would have had 10 tokens of A ($150) and 10 tokens of B ($100), totaling $250.

In this scenario, the impermanent loss is $0 because the value of the tokens held in the liquidity pool is the same as if they were held individually.

Now, let's consider a scenario where the price of token A decreases instead:

If the price of token A decreases to $5 while the price of token B remains unchanged at $10, the total value of the liquidity pool would decrease to $150 ($50 from token A and $100 from token B).

If the liquidity provider decides to withdraw their liquidity at this point, they would receive 10 tokens of A ($50) and 10 tokens of B ($100), totaling $150.

However, if the liquidity provider had simply held onto their tokens instead of providing liquidity, they would have had 10 tokens of A ($50) and 10 tokens of B ($100), totaling $150.

In this scenario, again, the impermanent loss is $0 because the value of the tokens held in the liquidity pool is the same as if they were held individually.

Therefore, impermanent loss only occurs when the relative prices of the assets in the liquidity pool change, causing the value of the assets in the pool to diverge from the value of those same assets held individually.