What is impermanent loss?

Impermanent loss is a concept associated with liquidity provision in decentralized finance (DeFi) platforms, particularly in decentralized exchanges (DEXs) and automated market makers (AMMs). When you provide liquidity to a pool by depositing an equal value of two assets (e.g., tokens) into a liquidity pool, you receive liquidity provider (LP) tokens in return.

Impermanent loss occurs when the value of the two tokens in the pool becomes imbalanced compared to the value of the tokens when you initially provided liquidity. This can happen when there are price fluctuations in the assets within the pool. The degree of impermanent loss depends on the extent of the price change and the specific formula used by the AMM.

The term "impermanent" is used because the loss is temporary and will only be realized if you decide to withdraw your liquidity from the pool while the price of the assets is imbalanced. If the prices return to their original levels, the impermanent loss diminishes, and in some cases, liquidity providers may even end up with higher returns than if they had simply held the assets.

Impermanent loss is a risk that liquidity providers need to consider, especially in volatile markets. It is essential to weigh the potential returns from fees earned by providing liquidity against the risk of impermanent loss. Different AMMs use different algorithms and mechanisms to mitigate impermanent loss to varying degrees.

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