Liquidity Pool Impermanent Loss

Impermanent loss occurs in decentralized finance when the price ratio of tokens in an automated market maker liquidity pool diverges from the ratio at which they were deposited. Because liquidity providers must maintain an equal value of both assets in a pair, the protocol automatically rebalances the pool as traders swap tokens.

If the price of one asset rises significantly relative to the other, the liquidity provider ends up holding more of the less valuable asset and less of the highly valuable asset compared to simply holding them in a wallet. It is called impermanent because the loss can be reversed if the prices return to their original ratio.

However, if the liquidity provider withdraws while the divergence persists, the loss becomes permanent.