What is impermanent loss?
Impermanent loss is a term familiar to liquidity providers. It refers to the temporary loss of funds an investor has provided to a liquidity pool. The difference is what liquidity provider’s assets are worth at the moment and how much they would have been worth if he just held his assets is the impermanent loss (IL).
IL usually occurs due to the volatility of the token pair. A typical liquidity pool has two assets. When one token appreciates or depreciates significantly relative to another one, it may result in IL. It is called impermanent because it is not realized until the moment liquidity provider withdraws funds from the pool.
Let’s say, SOL price is 40 USDC and a liquidity provider deposits 10 SOL and 400 USDC. Remember that it is necessary to provide the same amount of funds to both assets of the pools. The total value of the pool is 100 SOL and 4,000 USDC; so, our investor owns 10% of the pool. His total funds are worth 800 USDC (10 SOL + 400 USDC).
Let’s say the SOL appreciates 100% being worth 80 USDC. Arbitrageurs will trade until the values of both legs of the pool will be equal. Since total liquidity in the pool should remain constant, the new composition of the pool will be 70.7 SOL and 5,656 USDC. Liquidity provider will now have 7.07 SOL and 565.6 USDC which is worth 1,131 USDC.
It seems our investor has made more than 41% return: his 800 USDC investment is worth 1,131 USDC now. But what would happen if he had held his assets instead of providing liquidity? His investment would be worth 1,200 USDC (10 SOL + 400 USDC). Thus, he lost 5.72% relative to HODLing. This is an impermanent loss.