Impermanent Loss

Liquidity providers earn through fees and special pool rewards. However, they are also risking a scenario in which they would have been better off holding the assets rather than supplying them. This outcome is called impermanent loss.

Impermanent loss is the difference in net worth between HODLing and LPing. Liquidity mining helps to offset impermanent loss for LPs.

When the price of the assets in the pool change at different rates, LPs end up owning larger amounts of the asset that increased less in price (or decreased more in price). For example, if the price of CLAY moons relative to BTSG, LPs in the CLAY-BTSG pool end up with larger portions of the less valuable asset (BTSG).

Impermanent loss is mitigated in part by the transaction fees earned by LPs. When the profits made from swap fees outweigh an LP’s impermanent loss, the pool is self-sustainable.

To further offset impermanent loss, particularly in the early stages of a protocol when volatility is high, AMMs utilize liquidity mining rewards. Liquidity rewards bootstrap the ecosystem as usage and fee revenues are still ramping up.