Impermanent Loss: The Hidden Trap of Liquidity Providers

When You Deposit Tokens, You Might Lose More Than You Think

If you are considering providing liquidity to DeFi pools, there is a risk that you absolutely need to be aware of before locking up your funds. It is called impermanent loss (impermanent loss), and it is the reason why many liquidity providers find that they would have been better off simply holding their tokens.

What Are We Talking About?

Impermanent loss occurs when the price ratio of your assets changes after you deposit them in a pool. The greater this change, the greater the potential damage to your portfolio. In short: you could withdraw with less money than you would have if you had simply left the tokens in your wallet.

This happens because DeFi protocols rely on a special system called automated market maker (AMM). Unlike traditional exchanges, AMMs do not use order books. Instead, the price of tokens is determined by the ratio of the assets present in the pool itself.

Why Do Suppliers Continue to Take Risks?

Despite this danger, many people still provide liquidity. The reason? Trading fees. Every time someone trades tokens in the pool, liquidity providers earn a portion of that fee. If the trading volume is high enough, these fees can completely offset—or even exceed—the impermanent loss that accumulates.

However, profitability depends on many factors: the specific protocol, the token pair, the trading volume, and the general market conditions.

A Concrete Example: The Story of Alice

Imagine this scenario: Alice decides to provide liquidity with 1 ETH and 100 USDC in a pool. At the time of the deposit, 1 ETH is worth 100 USDC, so the total value of her position is $200.

In the pool, there are also 9 ETH and 900 USDC from other providers. This means that Alice owns 10% of the total liquidity of the pool.

What happens when the price of ETH rises to 400 USDC?

Arbitrage traders notice the misalignment. They start adding USDC to the pool and withdrawing ETH until the ratio reflects the new market price. Due to the mathematical formula that AMMs use (the constant product: x * y = k), the composition of the pool changes.

Now there are about 5 ETH and 2,000 USDC in the pool.

When Alice decides to withdraw her 10% share, she receives 0.5 ETH and 200 USDC. Let's calculate the value: 0.5 ETH at 400 USDC per ETH = 200 USDC, plus the 200 USDC received, for a total of 400 USDC.

It looks fantastic—he has doubled his money!

But wait. If Alice had simply kept her 1 ETH and 100 USDC in her wallet without providing liquidity, she would have 1 ETH ( now worth 400 USDC ) + 100 USDC = 500 USDC in total value.

Alice earned $400 but could have had $500. The difference of $100? That is the temporary loss.

How Much Could It Cost?

The risk varies depending on how much the price moves:

• Price movement 1.25x: loss of about 0.6%
• Price movement 1.50x: loss of about 2.0%
• Price movement 1.75x: loss of about 3.8%
• 2x Price Movement: approximately 5.7% loss
• 3x Price Movement: approximately 13.4% loss
• 4x Price Movement: approximately 20.0% loss
• Price movement 5x: approximately 25.5% loss

Attention: this loss occurs regardless of the direction of price movement. Whether the price goes up or down, what matters is only how drastically the ratio between the two assets changes.

An Important Detail: When It Becomes Permanent

The term “non-permanent” can be misleading. As long as your tokens remain in the pool, the loss is not yet realized. If you are lucky and the price ratio returns to the initial level, the loss disappears. But as soon as you withdraw your assets, any loss becomes permanent and real.

How to Protect Your Wallet

If you want to provide liquidity while minimizing risks:

1. Start small. Don't throw large amounts of capital in at the beginning. Experiment with smaller amounts until you understand how the mechanism works and what returns you can actually achieve.

2. Choose stable pools. Pairs between stablecoins linked to the same currency, or different “wrapped” versions of the same cryptocurrency, have a much lower risk of impermanent loss. Volatility is your enemy.

3. Be cautious of overly attractive returns. If a pool promises abnormally high returns, there is likely a greater hidden risk. Pools of new protocols that haven't been audited may contain bugs that trap funds.

4. Leverage modern designs. The latest AMMs offer alternatives such as concentrated liquidity or pools optimized for stablecoins, which significantly reduce the risk of impermanent loss.

The Complete Picture

Impermanent loss is not necessarily a reason to completely avoid providing liquidity. Many providers remain profitable thanks to fees. But it is essential that you understand this risk before investing your funds.

If the price of the assets you provide changes significantly compared to the time of deposit, you may end up with less value than you would have had simply holding the tokens. However, the fees earned may offset this loss—or not, depending on the volatility and trading volume of the pool.

Understand the risk. Start small. Choose smart pools. Only then decide if liquidity provision is right for you.