What Is Impermanent Loss in Crypto Liquidity Pools?
Decentralized finance (DeFi) platforms offer exciting opportunities to earn passive income by providing liquidity. But if you've been researching yield farming or liquidity pools, you've likely come across the term impermanent loss—a risk that can quietly eat into your earnings.
In this guide, we’ll explain what impermanent loss is, why it happens, and how to manage or reduce it when participating in DeFi protocols.
What Are Liquidity Pools?
Before understanding impermanent loss, it’s important to grasp the basics of liquidity pools.
In DeFi, liquidity pools are smart contracts that hold pairs of tokens to facilitate decentralized trading. Instead of traditional order books, automated market makers (AMMs) like Uniswap, PancakeSwap, or Balancer allow users to trade directly against a pool of assets.
Anyone can become a liquidity provider (LP) by depositing a 50/50 value ratio of two tokens into a pool—for example, ETH and USDT. In return, LPs earn a share of the trading fees generated by the pool.
But this seemingly simple strategy carries an invisible risk: impermanent loss.
What Is Impermanent Loss?
Impermanent loss occurs when the price of the tokens you’ve deposited in a liquidity pool changes compared to when you first deposited them. The greater the price change, the more you’re exposed to potential loss—compared to simply holding the tokens.
It’s called “impermanent” because the loss only becomes permanent if you withdraw your tokens after the price change. If prices return to their original state, the loss disappears.
Example:
Let’s say you deposit:
1 ETH (worth $1,000) and
1,000 USDT
into an ETH/USDT pool.
If ETH increases in value to $2,000, arbitrage traders will buy ETH from the pool (where it’s cheaper) and sell it elsewhere. To maintain a 50/50 value ratio, the pool will end up with less ETH and more USDT.
If you withdraw your funds now, you’ll have more USDT but less ETH than you originally deposited—and your total value will be lower than simply holding 1 ETH and 1,000 USDT outside the pool.
That difference is your impermanent loss.
Why Does Impermanent Loss Happen?
Impermanent loss is a byproduct of how AMMs work. Since prices in the pool are determined algorithmically based on the ratio of the two assets, any external price movement leads to arbitrage opportunities.
Traders exploit price differences between the pool and external markets (like centralized exchanges), which rebalances the pool but leaves LPs with a different token ratio.
The Bigger the Price Swing, the Bigger the Loss
The more volatile the token pair, the more risk of impermanent loss. For example:
Small fluctuations (±1–2%) = negligible loss
Large shifts (±50% or more) = significant loss
How to Calculate Impermanent Loss
Here's a quick reference chart for impermanent loss based on the price change of one token:
These losses are relative to simply holding the assets.
How to Minimize Impermanent Loss
While it can't be eliminated entirely, you can reduce impermanent loss with a few strategies:
1. Choose Stable Pairs
Pairing stablecoins like USDT/USDC or DAI/USDC results in lower price volatility—and thus, minimal impermanent loss.
2. Use Protocols With IL Protection
Some DeFi platforms (e.g., Bancor, ThorChain) offer impermanent loss protection or insurance over time.
3. Stay Short-Term in Volatile Pools
If you’re providing liquidity for a volatile pair (e.g., ETH/ALT), consider exiting before major price swings.
4. Look at Fees vs. Loss
If a pool has high trading volume and generous fees (e.g., 0.3% per trade), it can offset the impermanent loss. Always compare your projected fee earnings with potential IL.
5. Avoid Low-Liquidity Pools
Smaller pools are more easily manipulated and tend to suffer from higher slippage and IL.
Is It Still Worth Providing Liquidity?
Yes—if you understand the risks and choose your pools wisely.
Impermanent loss is just one side of the equation. The other is yield from trading fees and possible token rewards (like farming incentives). If these earnings outweigh the impermanent loss, then providing liquidity can still be profitable.
Final Thoughts
Impermanent loss is a key concept for any crypto trader or DeFi user to understand. It can significantly impact your returns if you’re not aware of it, especially in volatile markets.
Before diving into liquidity provision, consider:
The volatility of your token pair
The tradeoff between fees earned and IL risk
The overall health and volume of the pool
With the right strategy, liquidity provision can still be a lucrative way to grow your crypto portfolio—just make sure you’re not blindly chasing yield without understanding the mechanics behind it.
Start exploring DeFi safely on BitMart. Gain access to reliable trading tools, educational resources, and the latest crypto assets in one trusted platform.
