Impermanent Loss [CapiPedia]

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====== Impermanent Loss ======
Impermanent Loss is a risk unique to the world of [[Decentralized Finance (DeFi)]], representing a temporary, on-paper loss of funds experienced by investors who provide assets to a [[Liquidity Pool]]. This isn't a loss from a simple drop in an asset's price; rather, it's the difference in value between simply holding two [[cryptocurrency]] assets in your wallet versus depositing them into a pool. Imagine you deposit $500 worth of Asset A and $500 worth of Asset B into a pool. If the price of Asset A doubles while Asset B stays flat, the pool's rebalancing algorithm will leave you with less of the high-performing Asset A and more of the stable Asset B. When you withdraw, the combined value of your assets might be, say, $1,200. However, if you had just held them, their value would be $1,500 ($1000 from Asset A + $500 from Asset B). The $300 difference is your impermanent loss. The term "impermanent" is used because the loss only becomes real—or //permanent//—when you withdraw your assets from the pool. If the prices were to return to their original ratio, the loss would theoretically disappear.
===== How It Really Works: A Tale of Two Assets =====
To grasp impermanent loss, you first need to understand the environment where it lives: the [[Automated Market Maker (AMM)]]. Think of an AMM as a robot that allows people to trade cryptocurrencies without a traditional order book. It does this using Liquidity Pools, which are just big pots of paired assets contributed by investors like you, known as [[Liquidity Providers (LPs)]].
==== The Deal for Liquidity Providers ====
As an LP, you deposit an equal value of two different tokens (e.g., $1,000 of ETH and $1,000 of a stablecoin like USDC) into a pool. In return for providing this liquidity, you earn a share of the trading fees generated by that pool. This is the carrot. It's often marketed as [[Yield Farming]]—a way to make your assets "work for you." However, this is where the stick of impermanent loss comes in.
==== The Rebalancing Act ====
The AMM's core job is to maintain a constant balance of //value// between the two assets in the pool. Let's use a simple example:
  * **Initial Deposit:** You deposit 1 ETH and 2,000 USDC into a pool. At this moment, the price of 1 ETH is $2,000. Your total deposit is worth $4,000.
  * **Price Change:** The price of ETH rockets up to $8,000 on the open market.
  * **Arbitrage Happens:** Traders will now rush to your pool, where ETH is still implicitly cheaper. They will buy the cheaper ETH from the pool using USDC until the pool's price matches the market price.
  * **The New Pool Balance:** To maintain its balance, the algorithm sells your ETH as its price rises. Your share of the pool might now be 0.5 ETH and 4,000 USDC. The total value is now $8,000 (0.5 ETH x $8,000 + 4,000 USDC). You've doubled your money, right? **Not so fast.**
  * **Calculating the Loss:** What if you had just held your assets? You would have your original 1 ETH (now worth $8,000) and your 2,000 USDC. Your total value would be **$10,000**.
The difference between what you could have had ($10,000) and what you actually have in the pool ($8,000) is your **$2,000 impermanent loss**. The fees you earned would have to be greater than $2,000 just for you to break even with a simple [[HODL]] (Hold On for Dear Life) strategy.
===== The Value Investor's Perspective =====
For a practitioner of [[Value Investing]], the concept of impermanent loss should set off alarm bells. It highlights a fundamental clash between the principles of long-term, fundamental-based investing and the speculative, high-velocity nature of much of DeFi.
==== Risk You Can't Analyze ====
Value investors thrive on analyzing understandable businesses and buying them with a [[Margin of Safety]]. They study financial statements, management quality, and competitive advantages to calculate an [[intrinsic value]].
Impermanent loss is the opposite. It's a complex, algorithm-driven risk that is nearly impossible to predict. You are not investing in a productive asset; you are providing inventory for a trading system and betting that the trading fees you collect will outweigh the potential losses from asset price divergence. This is speculation, not investing.
==== The Illusion of Yield ====
The "yield" from providing liquidity is often presented as a form of income, akin to a dividend. This is a dangerous comparison. A dividend is a share of a company's real-world profits. The yield from a liquidity pool is a fee paid by traders, and it comes with the significant, often hidden, risk of giving up the upside of your best-performing asset. The promised high Annual Percentage Yield (APY) can be quickly wiped out by impermanent loss in a volatile market.
In short, impermanent loss is a feature of a system designed for traders and speculators. It fundamentally works against the investor who seeks to buy and hold great assets for the long term. A value investor's time is better spent analyzing a company's cash flow than trying to outsmart a pricing algorithm.