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Difference between revisions of "Impermanent loss"
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(Created page with "Impermanent loss (commonly abbreviated as IL) is one of the fundamental concepts introduced by DeFi. It is the main risk, beside token volatility of the user who wishes to provide liquidity in AMMs. Impermanent loss causes most LP position to be unprofitable and, given its non-intuitive nature, is often misunderstood by beginners. == Definition == Impermanent loss is the loss an LP (liquididy provider) is potentially subject to when he '''provides liquidity in a AMM poo...") |
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== Why it happens == | == Why it happens == | ||
Liquidity pool based AMMs (like [[Uniswap]], [[Pancakeswap]] or [[Sushiswap]]) all work under one simple formula: x * y = k, where x and y are the amount of tokens in the pool, and k is their product, which has to remain '''constant'''. | Liquidity pool based AMMs (like [[Uniswap]], [[Pancakeswap|PancakeSwap]] or [[Sushiswap]]) all work under one simple formula: x * y = k, where x and y are the amount of tokens in the pool, and k is their product, which has to remain '''constant'''. | ||
Understanding this mechanism is pivotal to understand why impermanent loss really happens. | Understanding this mechanism is pivotal to understand why impermanent loss really happens. | ||
Since k, the product of the two pool reserves, must remain constant, whenever the price of one token changes relatively to the other, so will the reserves. In particular, the pool always tries to keep a balanced proportion of the two assets: when the price of token A drops relatively to token B, there will be more of token A and less of token B in the pool. Thus a liquidity provider, which owns a portion of the pool, will see its token A holdings grow and its token B holdings shrink. Since A's price has dropped, he's now suffered impermanent loss. | Since k, the product of the two pool reserves, must remain constant, whenever the price of one token changes relatively to the other, so will the reserves. In particular, the pool always tries to keep a balanced proportion of the two assets: when the price of token A drops relatively to token B, there will be more of token A and less of token B in the pool. Thus a liquidity provider, which owns a portion of the pool, will see its token A holdings grow and its token B holdings shrink. Since A's price has dropped, he's now suffered impermanent loss. | ||