Impermanent Loss in DeFi: The Complete Guide

Impermanent loss is a risk in DeFi liquidity pools where the value of your deposited assets changes, potentially resulting in less profit than if you had simply held the cryptocurrencies outright.

Written by: Anatol Antonovici   |  Updated December 28, 2023

Reviewed by: Mike Martin

Fact checked by: Ryan Grace

crypto scale

Impermanent loss is a risk affecting liquidity providers who add crypto assets to the pools of decentralized exchanges (DEXs). In this guide, we’ll show you how it works and the best ways to avoid impermanent loss!

Table of Contents

🍒 tasty takeaways

  • Impermanent loss in DeFi occurs when the return on providing liquidity to a DEX is less than holding the assets due to price changes.

     

  • Liquidity providers can offset impermanent loss through trading fees, especially in high-volume pools on major DEXs.

     

  • Risk reduction strategies include participating in stablecoin pools, timing market volatility, and diversifying across multi-asset pools.

Impermanent Loss Summary

Term Description
Impermanent Loss Potential reduction in earnings for LPs in DEXs due to crypto price shifts.
Liquidity Provision DEXs use AMMs for trading; LPs contribute to pools and earn fees.
DEXs Decentralized exchanges that allow for token trading without intermediaries.
AMM Automated Market Maker, a type of DEX that uses algorithmic token pools for pricing.
LP Tokens Tokens received by liquidity providers that represent their share in the pool.
Stablecoins Cryptocurrencies pegged to stable assets like fiat, less prone to impermanent loss.

How Liquidity Provision in DeFi Works

Decentralized crypto exchanges, also known as DEXs, are the second most used application category in DeFi, right after decentralized lending. As of November 2023, DEXs have more than $11.5 billion in total value locked (TVL).

Source: DeFiLlama

DEXs facilitate token trading without middlemen by using an Automated Market Maker (AMM) algorithm instead of a traditional order book.

DEXs operate autonomously with smart contract-based liquidity pools. These pools can represent token pairs or funds comprising multiple tokens. On one side, users trade tokens against these pools by connecting their self-custody wallets, and on the other side, liquidity providers (LPs) add funds to the pools in exchange for rewards from trading fees.

🍒 Go In-Depth: Liquidity Pools Explained

Democratizing Market Making

Anyone can become an LP by adding funds to a liquidity pool. For example, you can connect your tastycrypto Web3 wallet to the USDC/ETH pool on Uniswap and deposit an equal amount of USDC and ETHETH is the native cryptocurrency behind the Ethereum network and USDC is a stablecoin pegged to the US Dollar. 

So why would you want to be a LP? Because you earn the fees customers pay every time they trade the assets within your pool! 

 🎬 Watch a USDC/ETH Liquidity Pool in Action! 

Liquidity provision, AKA liquidity mining, presents a great DeFi yield-generating