In DeFi, what is "impermanent loss"?

In DeFi, users can provide liquidity to decentralized exchanges (DEXs) through what are called liquidity pools. These pools allow users to deposit pairs of cryptocurrencies (e.g., Ethereum and a stablecoin like USDC) to enable trading between these pairs on the exchange.

Impermanent loss occurs when the price of the deposited assets changes compared to when they were deposited. Here's a step-by-step explanation:

Providing Liquidity: You provide two cryptocurrencies to a liquidity pool in equal value. Let’s say you deposit 1 ETH and 100 USDC, assuming the price of 1 ETH is 100 USDC at the time.
Price Movement: If the market price of ETH increases to 150 USDC, the ratio of the two assets in the pool changes. Automated market makers (AMM), which control the ratios, adjust the amount of ETH and USDC in the pool to maintain the constant product formula.
Withdrawal: When you withdraw your liquidity, you'll likely end up with less ETH and more USDC compared to your initial deposit. The divergence in price causes your initial deposit to be worth less in dollar terms than if you had simply held onto your original ETH and USDC separately.
Why 'Impermanent'? This loss is termed 'impermanent' because if the prices return to their original levels (the same levels as when you deposited them), the loss disappears. However, if you withdraw your funds before the price reverts, then the loss becomes permanent.
Why It Matters: Understanding impermanent loss is crucial for liquidity providers because even if they earn fees from trades occurring in their pools, those fees might not always cover the loss incurred from price fluctuations.

Impermanent loss can be mitigated by careful selection of asset pairs with low volatility or by using platforms that offer rewards to offset these potential losses. Being aware of market trends and asset performance is also vital for anyone wishing to minimize the impact of impermanent loss.