Impermanent loss is the difference between the value of a liquidity-provider position and the value the same assets would have had if they had simply been held outside the liquidity pool. The effect is most common in pools where the quantities of assets automatically change as their relative market prices change.

Consider a simple pool containing two assets. If the price of one asset changes significantly relative to the other, arbitrage traders trade against the pool until the pool price moves closer to the external market price. This process changes the quantities of both assets held on behalf of the liquidity provider.

If the resulting position is compared with simply holding the original assets, the liquidity-provider position may be worth less. This relative difference is called impermanent loss.

The term refers to the fact that the effect depends on the current relative prices. If prices return to their original relationship, the calculated impermanent loss can decrease or disappear. If the provider withdraws liquidity while the price relationship is unfavorable, the difference becomes effectively realized.

Impermanent loss does not necessarily mean that the provider has lost money in absolute terms. The position can simultaneously earn trading fees and additional incentives. The final result depends on the balance between these revenues and the relative loss caused by price changes.

Factors affecting impermanent loss

  • the change in relative asset prices;
  • the mathematical design of the liquidity pool;
  • the amount of time liquidity remains deployed;
  • trading fees earned by the provider;
  • additional protocol incentives;
  • changes in the absolute value of the underlying assets.

Liquidity providers should therefore evaluate impermanent loss together with fees, transaction costs, asset volatility, and smart-contract risk rather than evaluating the advertised APY alone.