# Impermanent Loss: The Silent Cost of Providing Liquidity

By [Ammalgam](https://paragraph.com/@ammalgam-2) · 2026-01-09

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Impermanent loss is one of the most misunderstood risks in DeFi. New users hear about “earning yield” by providing liquidity and assume it resembles interest on a savings account. It does not. Automated Market Makers (AMMs) change the structure of your position every time the market moves. If you do not understand that mechanism, you cannot evaluate the risk or the return.

Impermanent loss is the difference between what your assets would have been worth if you had simply held them and what they are worth after the AMM has rebalanced them. That gap can be small or large, but it is always measurable and always matters.

### Why Impermanent Loss Exists

AMMs emerged in 2020 with the intent to solve a practical problem. Early DEXs used order books, but blockchains were too slow and too expensive. AMMs replaced active market-makers with passive liquidity pools built on simple formulas. The most common model — the **constant-product formula** — enforces a strict rule:

x×y=kx \\times y = kx×y=k

Where:

*   xxx = amount of token A in the pool
    
*   yyy = amount of token B in the pool
    
*   kkk = a constant that never changes
    

This formula guarantees that **if one asset’s price rises, the pool must reduce its quantity**, and if one falls, the pool must increase its quantity. The AMM keeps x×y=kx \\times y = kx×y=k at all times by automatically rebalancing the pool’s inventory.

When prices move, this math forces the AMM to:

*   **sell the asset that is going up**
    
*   **buy more of the asset that is going down**
    
*   **and adjust the pool until the ratio reflects the new market price**
    

None of this is optional.

Liquidity providers inherit these trades automatically, even if they would never choose them manually. This is the mechanism that creates impermanent loss.

### Why IL Matters

If you provide liquidity without understanding this, you can earn fees every day but still lose money in total performance. Many new users only look at the APY shown on the interface. They do not compare their final withdrawal value to what they would have made by simply holding the assets. Impermanent loss matters because it shows whether liquidity provision is actually profitable after accounting for the structural effects of the AMM.

When markets move in one direction for long periods and volatility pushes assets apart, impermanent loss increases. Even when one asset moves while the other barely changes, the mismatch creates impermanent loss. These are routine market conditions; users encounter them constantly. Ignoring this risk distorts expected returns.

However, impermanent loss **can shrink** under certain circumstances. If prices revert back toward the original ratio, or if trading fees earned during the period exceed the loss from rebalancing, the LP may experience a net positive return. This is the only mechanism through which LPs can “beat holding” inside an AMM.

### Illustrating With an Example - Mean-Reverting Market (Impermanent Loss Shrinks, Fees Can Outperform)

Let's look at a 50/50 ETH–USDC pool at a price of ETH at $3,200:

*   1 ETH ($3,200)
    
*   3,200 USDC
    
    Total: **$6,400**
    

ETH first rises to **$3,700**, then pulls back to **$3,200**.

### Scenario 1: Simply Holding

Your final holdings are unchanged:

*   1 ETH ($3,200)
    
*   3,200 USDC
    
    Total: **$6,400**
    

### Scenario 2: Inside the AMM

As ETH rose to $3,700, the AMM temporarily rebalanced your position by selling a small portion of ETH and buying USDC.

When ETH returned to **$3,200**, the pool ratio returned close to its initial state.

Your portfolio ends up near:

*   **0.99 ETH**
    
*   **3,220 USDC**
    

Total value at final price:

*   0.99 ETH × $3,200 = **$3,168**
    
*   3,220 USDC = **$3,220**
    
*   Total: **$6,388**
    

This is **~$12 below holding** - a relatively small IL amount.

But now add a simple fee assumption:

If the pool earned **0.3% fees** on just **$80,000 of volume** during this period, your LP share (say 1%) earns:

Fee income:

*   $80,000 × 0.3% × 1% = **$24**
    

Final performance:

*   Fee income ($24) – IL ($12) = **+$12 net gain**
    

This is the scenario where LPs _can_ outperform:

*   volatility stays within a band,
    
*   prices revert,
    
*   fees exceed the rebalancing loss.
    

AMMs were originally designed specifically for these conditions - **high volume, mean-reverting assets**.

### Why LPs Sometimes Do Worse Than Holding

The AMM forces you to sell the appreciating asset while it climbs. You would not choose this manually. A rational investor lets winners run. The AMM does the opposite: it continuously sells strength and buys weakness. As prices diverge, your portfolio diverges from what you would logically hold. That divergence grows the longer the trend lasts.

This is why LPs in volatile markets often underperform. They did not “lose” tokens in the normal sense. They simply ended up with an inferior mix of assets.

### Why Fees Do Not Always Offset Losses

Fees compensate LPs for taking on risk. But this only works if:

*   trading volume is high
    
*   the price oscillates around a mean
    
*   swings are contained
    
*   the fee tier matches the volatility profile
    

Most pools fail at least one of these conditions. If the market moves directionally, fees rarely catch up. If volume is low, fees are negligible. If volatility is high, the losses outpace the income. This is why many LPs who think they earned a high APY eventually discover they earned less than if they had simply held their assets.

So you see the predicament that liquidity providers face: fee income does not guarantee positive performance.

### How Impermanent Loss Became a Standard Risk in DeFi

The early DeFi boom prioritised accessibility over market structure. AMMs made trading available to anyone with a wallet. They removed gatekeepers, simplified liquidity provision, and enabled thousands of tokens to trade without professional market-makers. The trade-off was structural. Retail users carried risks that, in traditional markets, would be absorbed by specialists who understand inventory exposure.

AMMs never promised optimal execution for LPs. They promised reliability and simplicity. Impermanent loss is the cost of that simplicity.

### Why This Matters Today

As liquidity fractures across multiple chains, pools become shallower. Shallow pools magnify price impact and worsen impermanent loss. Retail users often carry this load without realising it. More sophisticated actors avoid providing liquidity in volatile assets entirely. This leaves the system dependent on participants who do not understand the risk. It is unsustainable.

Understanding impermanent loss is not optional. It is part of evaluating whether liquidity provision aligns with your goals, risk tolerance, and time horizon.

### How Ammalgam Reconfigures IL

Impermanent loss exists because of how AMMs structure liquidity. They mix two risks into one position:

*   inventory exposure
    
*   execution for traders
    

[Ammalgam](https://ammalgam.xyz/) restructures the entire flow. Liquidity is pooled once instead of being sliced across pairs, and price discovery happens locally without forcing the system to sell one asset to buy another. This removes the mechanism that creates impermanent loss in the first place - the continuous rebalancing that AMMs rely on.

But eliminating IL is only one part of what the architecture unlocks.

Because liquidity sits in a unified base layer, Ammalgam can route it toward multiple productive uses at the same time: market-making, lending, hedging, and risk-borrowing. Traders still get deep execution, but LPs are no longer the ones absorbing every adjustment. Other participants can borrow that exposure and take on the directional risk voluntarily and get compensated for doing so.

This structure turns liquidity from something that _bleeds_ into something that can _earn_.

LPs gain access to yield streams that come from actual usage - not dilution, not incentives, not pool-splitting. And because the system isn’t rebalancing their assets against every price movement, their returns aren’t eaten away by volatility.

This means:

*   LPs keep their upside instead of paying it out to arbitrageurs.
    
*   Users avoid the silent losses built into AMM design.
    
*   Liquidity becomes more productive
    

Impermanent loss has always been an architectural outcome. Fixing it meant designing a new architecture, not adjusting fees or deepening pools. Ammalgam does both: removes the loss mechanism and opens the door to higher-quality, higher-utility yield from the same liquidity.

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*Originally published on [Ammalgam](https://paragraph.com/@ammalgam-2/impermanent-loss-the-silent-cost-of-providing-liquidity)*
