What is impermanent loss

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Malcolm Dare

Impermanent loss (IPL) is a risk that can occur when providing liquidity to a decentralized finance (DeFi) protocol, specifically when providing liquidity to an automated market maker (AMM) liquidity pool.

An AMM is a type of smart contract on the blockchain that allows users to trade assets without the need for an order book. Instead, it uses a mathematical formula to determine the price of an asset based on the amount of supply and demand in the liquidity pool.

When a user provides liquidity to an AMM pool, they are typically required to deposit an equal value of two different assets. For example, if a user wants to provide liquidity to a trading pair of BTC/USDC, they would need to deposit an equal value of BTC and USDC. In return, they receive liquidity tokens that represent their share of the pool.

The risk of IPL arises when the value of the assets in the pool changes in such a way that the user's share of the pool becomes worth less than the value of the assets they deposited. For example, if the value of BTC in the pool increases relative to USDC, the user's share of the pool will decrease in value.

In other words, IPL is the potential loss of value that liquidity providers may face due to the volatility in the assets they provided to the liquidity pools. This is a risk because the value of the assets in the pool can fluctuate, and the liquidity provider may not be able to withdraw their assets at the same value they deposited.

It's important to note that IPL is not a guaranteed loss and it can also be reduced by monitoring the pools, adjusting the amount of assets provided or choosing pools with a low IPL risk. Also, it's important to consider the trading volume and the liquidity of the pool, as well as the overall health of the network of the DeFi project.

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