Impermanent Loss

The temporary loss of funds experienced by the liquidity providers occasionally due to the volatility of the market is known as impermanent loss. This indicates the amount of money one could have if they would have held on to their assets.

There are two types of assets present in a liquidity pool. One can be a stablecoin, while the other is usually a volatile crypto asset. The liquidity provider has to offer equal liquidity to both the assets but there might arise a situation where the more volatile crypto assets see a surge in their prices. This then leads to an opportunity for arbitrage because the price of the volatile asset present within the pool does not indicate the actual price of the same asset. To restore the equilibrium, the other traders will continue to buy the volatile asset until both of them achieve the same price.

At the end of this arbitrage, the liquidity provider naturally ends with the stablecoin which is slightly less as compared to the other asset. The current value of the assets is assessed as an impermanent loss against what would they be actually worth, had there been no volatility.