Impermanent Loss

What is Impermanent Loss?

Impermanent Loss is a temporary decline in the value of digital assets deposited in a liquidity pool compared to their value if held directly.

Definition of Impermanent Loss

Impermanent loss is defined as a temporary, unrealized loss in capital value that occurs when providing liquidity to liquidity pools for an automated cryptocurrency market maker instead of holding the cryptocurrency directly in a wallet. It occurs due to the rebalancing of cryptocurrency proportions within the liquidity pools, and this loss remains unrealized unless the liquidity is withdrawn.

An example of impermanent loss

Abdullah deposited $940 worth of Ethereum (equivalent to 0.4 ETH; today's Ethereum price is $2,350) and $940 worth of USDT into an ETH/USDT liquidity pool, for a total of $1,880. After some time, the price of Ethereum fell by 50% to $1,175, while USDT maintained its value. Due to the automatic rebalancing of currency ratios within liquidity pools, the value of Abdullah's deposit changed from: 0.4 ETH + 940 USDT to 0.566 ETH + 566 USDT. The USDT portion changed even though its price remained stable, as a result of the rebalancing mechanism in the liquidity pools, bringing the total value of the deposit in the liquidity pool to $1,231, whereas if he had kept the cryptocurrencies in his wallet, the value of his wallet after the drop would have been $1,410.

Hedging against impermanent loss

There are several ways to hedge against the risk of impermanent loss, the most well-known of which are distributing your deposits across multiple liquidity pools, using stablecoins alongside highly volatile coins, and conducting a thorough due diligence before making any investment decision.

Related Term: An unrealized loss is a temporary loss in the value of a portfolio displayed on the trading screen that has not yet been realized.

Compliance disclaimer

Warning: investing in cryptocurrencies involves significant risks, and you may lose some or all of your capital. This content is for educational purposes only and does not constitute investment advice. Consult a licensed financial advisor before making any investment decisions.