Impermanent Loss

Impermanent loss is a term used in liquidity provision for automated market maker (AMM) protocols such as Sinfonia, Osmosis, and others. When a liquidity provider (LP) adds funds to a liquidity pool, they are issued LP tokens representing their share in the pool. LP tokens are fungible and can be freely traded, but they represent a proportional ownership of the underlying assets in the pool.

Impermanent loss refers to the temporary loss of value that liquidity providers may experience when they supply liquidity to a pool that experiences a change in the relative prices of the tokens in the pool. This happens when the price of one token in the pool rises relative to the other token(s), causing the LP's share of the pool to shift in value compared to the initial value of the assets they deposited. The impermanent loss occurs because the LP would have been better off simply holding the assets outside the pool rather than supplying liquidity to the pool.

The term "impermanent" is used because the loss is not realized until the LP removes their funds from the pool. If they keep their funds in the pool long enough, the relative prices of the tokens may revert back to their original ratio, and the LP's loss will become "permanent" if they withdraw their funds at that time.

The impermanent loss is typically calculated by comparing the value of the LP's original deposit with the value of their LP tokens at the time of calculation. The actual impermanent loss will depend on the specific token pairs in the pool, the relative price changes of those tokens, and the time period for which the LP has provided liquidity.

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).

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.