What is Impermanent loss ?

Impermanent loss is a term commonly associated with decentralized finance (DeFi) platforms, particularly those that involve liquidity provision in automated market makers (AMMs) like Uniswap or PancakeSwap. To understand impermanent loss, let's first break down how liquidity provision works.

In these platforms, users can provide liquidity to a pool by depositing an equal value of two different assets. For example, in a Uniswap pool for ETH and DAI, a liquidity provider might deposit $1,000 worth of ETH and $1,000 worth of DAI. The provider receives liquidity tokens representing their share of the pool.

Impermanent loss occurs when the price of the two assets in the pool diverges. If the price of one asset increases relative to the other, the liquidity provider may experience a loss when compared to simply holding the assets. This loss is termed "impermanent" because it diminishes or disappears as the asset prices revert to their original ratio.

The term "impermanent" highlights that the loss is not realized until the liquidity provider decides to withdraw their funds from the pool. If the market moves in a way that benefits the LP, they may not experience any loss at all. Impermanent loss is essentially the trade-off for earning fees as a liquidity provider in AMMs, where your funds are automatically used for trading and market-making activities.

In summary, impermanent loss is a temporary and potential loss of value experienced by liquidity providers in decentralized exchanges due to fluctuations in the prices of the assets they provide liquidity for. It underscores the dynamic nature of DeFi markets and the risks associated with participating in liquidity pools.