Impermanent Loss: What is it and when does this phenomenon appear

The idea of impermanent loss mainly pertains to liquidity providers in decentralized finance (DeFi) networks, especially those that employ automated market maker (AMM) protocols. It describes the brief loss of value that liquidity providers may go through as a result of the volatile asset prices they have supplied liquidity for.

Liquidity providers add assets to a liquidity pool in AMM protocols, which is then used to enable decentralized trading. Users can trade among the assets since the pool keeps their relative proportions constant. In proportion to their portion of the overall liquidity provided, liquidity providers receive fees for joining the pool.

The ratio of the assets held by the liquidity provider may differ from the price of the external market when the price of the assets in the liquidity pool changes. This results in a situation where the liquidity provider’s asset value in the pool is different from what it would have been if they had retained the assets outside the pool.

When assets in the pool have lost some of their value since the liquidity provider placed them, this is known as an impermanent loss. If one asset performs much better than the other in the pool, the liquidity provider will own more of the underperforming asset than they would have otherwise, which will cause a brief decline in value.

The loss is only considered “permanent” because it can be reduced or even eliminated when the relative…