Impermanent Loss

Understand the Risks of Liquidity Pools

When a liquidity provider (LP) experiences a temporary (“paper loss”) when providing liquidity in a particular asset pair (DAI/ETH) where one of the assets is volatile (ETH). In general it is the price divergence between if you “Hodl” or if you choose to become an LP. This only happens on DEXs which employ AMM structures (Uniswap).

The key to remember is that when acting as the Liquidity Provider (LP) you can experience impermanent loss whether or not the price of your pair goes up or down. It simply comes down to the volatility of the pair you are providing. A DAI/ETH 50/50 pool will be more volatile than a DAI/USDC (stablecoin) 50/50 pool.

Liquidity providers (LP) choose to expose themselves to impermanent loss because they earn trading fees for providing liquidity. In high volume pools these fees are often greater than the impermanent loss LPs are exposed to resulting in profits.

Video by: Finematics

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