If you’ve ever considered generating additional income by supplying liquidity to a cryptocurrency exchange, you must be aware of impermanent loss. This happens when the price of the tokens you deposited into a pool changes compared to when you first put them in. The bigger the price swing, the more you lose compared to if you had just held those tokens in your own wallet.
It’s called “impermanent” because if the prices return to exactly where they were when you deposited them, the loss disappears. But if you withdraw your money, while the prices are still down or up then that loss becomes very permanent.
Imagine you join a liquidity pool for a new pair: Token A and Cash Coin. To keep things balanced, you deposit 10 units of Token A (worth $100) and $100 in Cash Coin. Your total investment is $200.
- The Market Moves: Suddenly, Token A becomes super popular and its price doubles on other exchanges.
- The Arbitrage: Savvy traders will jump into your pool to buy your “cheap” Token A until the price matches the outside market.
- The Result: When you go to withdraw your funds, you’ll find you have less Token A and more Cash Coin than you started with. Even though your total value might be, say, $250, you realize that if you had just kept your 10 tokens and $100 in your wallet, you’d actually have $300.
That $50 difference is your impermanent loss. You basically missed out on extra gains because the pool’s math forced you to sell your “winning” asset while it was going up.
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It’s the price you pay for being a “market maker,” and you usually hope the trading fees you earn will be high enough to cover that gap.