If you are new to the world of DeFi then you’re not familiar with the term “impermanent loss”. What is it? Where does it come from, and why does it happen?

Impermanent loss is accrued because of a change in the price of liquidity in a liquidity pool, different from its price when it was deposited. When the degree of change in the price is high, the liquidity provider, that is, the depositor stands a higher chance of being exposed to more loss.

There are some pools with assets having low risks of impermanent loss because they can stay in a relatively low price range. Such as Stablecoins.

If impermanent losses exist, why do liquidity providers still provide liquidity?

The answer is trading fees, which happens to be the reason the liquidity pools on Uniswap, although very exposed to impermanent losses, are still profitable.

Since trading fees go directly to liquidity providers, when there’s a lot of trading volume in the pool, liquidity providers profit from it even if it’s highly exposed to impermanent loss.

Take, for instance, a liquidity provider deposits 100 DAI and 1 ETH in a given pool with an automated market maker that requires the deposited token pair to have an equivalent value. That is, 100 DAI equals 1 ETH, and equals $200.

If other liquidity providers, say nine more, deposit as much as the initial liquidity provider, then there will be 10 ETH and 1,000 DAI, each having 10% of the pool.

If 1 ETH increases to 400 DAI, arbitrage crypto traders will add DAI to the pool and take ETH.

Because of the arbitrage traders, the pool now has 2000 DAI and 5 ETH. If the liquidity provider decides to withdraw, they get 0.5 ETH and 200 DAI. That is 10% of the pool, equating to $400. That is $200 more than was deposited.

If the providers held their 1 ETH and 100 DAI, it would be worth $500 now, a difference of $100. The $100 is the impermanent loss. Although trading fees have not yet been factored in, it could help negate the losses.

This may look small to you, but you could lose even more, even a substantial amount of your initial deposit.

Making it important to understand impermanent losses before providing liquidity to automated market makers.

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