What is impermanent loss in crypto?

Impermanent loss is the gap between what your tokens are worth inside a liquidity pool and what they would have been worth if you had simply held them in your wallet. It happens when the prices of the tokens in the pool move apart, and it is called “impermanent” because it shrinks again if prices return to where they were when you deposited.

What is impermanent loss in crypto?

Impermanent loss in crypto is an opportunity cost for liquidity providers: the value you miss out on by providing liquidity instead of holding the same assets. It is measured against holding, not against your initial deposit, so you can have impermanent loss and still be up in absolute terms.

The word “impermanent” is misleading. The loss is only temporary while your money stays in the pool and prices may still come back. Once you withdraw, it becomes a real, permanent difference. Many liquidity providers accept the risk of impermanent loss because they earn trading fees that may make up for it.

How impermanent loss happens in DeFi liquidity pools

Impermanent loss happens because a liquidity pool keeps rebalancing your tokens whenever prices change. You don’t own a fixed number of each token; you own a share of the pool, and the mix of tokens in the pool changes with every trade.

How automated market makers rebalance

Most decentralised exchanges run their pools with automated market makers that use the constant product formula, x × y = k: the amounts of the two tokens multiplied together must stay constant. When the market price of ETH rises on other exchanges, the pool’s price is suddenly too low. Arbitrage traders buy the cheap ETH from the pool until its price matches the external price, which leaves the pool with less ETH and more of the other token.

Your share follows the pool. You end up with fewer of the token that went up and more of the token that stayed flat. If ETH falls instead, the opposite happens and you end up holding more of the falling token. Impermanent loss occurs in either direction: only the size of the price change matters.

Impermanent loss example in euros

Here is a worked impermanent loss example with round numbers, ignoring fees for clarity. Say you deposit €1,000 into an ETH/EURC pool (EURC is a euro stablecoin) when ETH costs €2,000: 0.25 ETH worth €500 plus 500 EURC, equal value on both sides.

Then ETH doubles to €4,000. The pool rebalances your share to about 0.177 ETH and 707 EURC.

Your position grew from €1,000 to €1,414, so you made money in absolute terms. But simply holding would have given you €1,500. The €86 difference, 5.7% of the hold value, is your impermanent loss. If ETH had halved to €1,000 instead, holding would be worth €750 and your pool share €707: the same 5.7% gap, on top of the loss from the falling price.

How to calculate impermanent loss

To calculate impermanent loss in a standard 50/50 pool you only need the price ratio: how much one token’s price has changed relative to the other since you deposited. The formula is 2 × √r ÷ (1 + r) − 1, where r is the new price ratio divided by the original ratio.

This impermanent loss estimation leaves out swap fees and yield farming rewards, and it only applies to 50/50 constant product pools. Pools with other weights behave differently, and with concentrated liquidity the loss for the same price move can be several times larger.

What makes impermanent loss risk larger?

Impermanent loss risk grows with price divergence: the further the two tokens’ prices drift apart, the bigger the loss. Three things decide how far that goes.

• Price volatility. Volatile pairs, such as a small altcoin against a stablecoin, can see massive price swings and substantial impermanent loss.
• Correlation. Correlated assets that tend to move together, such as two dollar stablecoins, show little divergence and low IL risk. Not all liquidity pools are equal, though: a stablecoin that loses its peg turns a “low-risk” pool into a large loss.
• Concentrated liquidity. Providing liquidity in a narrow price range earns more fees per euro but magnifies the loss once the price leaves that range.

Impermanent loss vs trading fees

Liquidity providers earn trading fees on every swap, and those fees are what can offset impermanent loss. The real question is whether the trading fees earned outweigh it.

In the example above, if your share of the trading fees generated over that period came to €60, you would be €26 behind holding instead of €86. High volume pools with heavy trading volume produce more fee income; low volume pools may never earn enough. Be wary of a very high advertised yield: projects often pay out governance tokens to attract liquidity, and those yield farming rewards can fall in value faster than fees come in.

When does impermanent loss become permanent?

Impermanent loss becomes permanent when you withdraw while prices are still away from the original ratio. If prices return to where they were when you deposited, the loss disappears, which is why it’s called a temporary loss.

In practice, prices rarely return exactly to the starting point. Treat impermanent loss as a real cost when you plan, not as something that will fix itself.

How to manage impermanent loss

You can’t avoid impermanent loss entirely in a two-token pool, but you can manage impermanent loss with a few habits:

• Start with a small position you can afford to lose.
• Prefer correlated pairs if you want lower risk, and accept that they usually pay lower fees.
• Compare projected fee income with a few price scenarios from the table before you deposit.
• Avoid unaudited protocols and new pools whose rewards look too good to be true.
• If a protocol offers single-sided liquidity or “protection”, read exactly who carries the risk and what happens if the protocol runs out of money.

Is providing liquidity worth it?

Providing liquidity is only worth it if the fees you expect clearly beat impermanent loss in realistic price scenarios, and you accept the smart contract risk on top. For most beginners, simply holding the tokens is easier to understand and cheaper to manage.

Avoid volatile pools if you can’t check your position regularly or need the money soon. Pools on DeFi protocols generally sit outside MiCA, so there is no regulator or investor compensation scheme if something goes wrong. Crypto-assets are volatile and you can lose some or all of the money you put in.

Taxes and record-keeping in the EU

Tax treatment of liquidity pools varies by country. Depending on where you live, depositing tokens, receiving LP tokens, earning fees and claiming rewards may each be treated differently, so check the guidance of your own tax authority.

In the Netherlands, crypto falls into box 3 and is taxed on its value on 1 January rather than per trade. Wherever you live, keep a record of every deposit, withdrawal, reward and network fee: you will need them to work out your real return.

Related terms

• Liquidity Pool
• AMM
• DEX
• DeFi
• Yield Farming