In this section we describe what impermanent loss is, how it occurs, the risks associated with it, and how our users can recognize the potential effects on their investment decisions.
Impermanent Loss is an extremely hot topic within decentralized finance and rightfully so. Often liquidity providers are supplying funds to a pool with a surface level understanding of how impermanent loss can affect their position. While commonly discussed as potentially wipe out the value of an entire pool or slowly chip away at their potential gains the tradeoff of volatility harvesting is not often emphasized.
The reality of impermanent loss is that it is a dynamic and reversible occurrence which is only realized when a position is removed from a liquidity pool, at this point is becomes a permanent loss. The liquidity provided is an investment on either volatility or that both assets will show extremely similar price action while accumulating trading fees. The fees are a tax paid by traders and in some cases traders are called “arbitragers”. These fees are awarded to the liquidity provider and the market making platform (in most cases) in order to incentivize the holder of a liquidity position to continue to give them a trading source.
Impermanent loss occurs when the prices of two assets experience a divergence in price action. For example if two assets increase by 20% no impermanent loss is noticed. However if one asset increases in value by 20% then a divergence has taken place and some form of impermanent loss would be noticed in the position. This can be reversed by the other token in the pool also increasing 20% or both tokens converging on the same price movement relative to the original investment. A basic example of impermanent loss followed by reversal scenario are is outlined on the following page.
Impermanent Loss - Relationship shown based on a two token pool with one asset and one stable coin.