Transaction fees provide passive income for LP providers, but putting tokens into liquidity pools is still risky . In fact, when withdrawing their share of tokens from the pool, LPs often find that the value of those tokens is less than what they would have had by purely HODLing, without taking transaction fees into account. Sometimes even the gains from LP fees are not enough to cover losses.

This phenomenon is called impermanent loss. Impermanent loss can be thought of as an opportunity cost, which occurs every time the price of a token in a pool deviates from its initial price when it was put into the pool. That's why it's called "impermanent": as soon as the price returns to the level where it was put into the pool, the loss disappears. The diagram below shows this relationship nicely.

Let us understand this concept through an example.

A simple example of impermanent loss

Suppose you open a liquidity pool with 20 ETH and 80 USDT (stable coins worth 1 USD each) Sex pool.

At the same time, ETH is also listed on the centralized exchange, with the latest price being 1 ETH=8 USDT

John is very familiar with the constant product AMM mechanism. Did some simple calculations and discovered an arbitrage opportunity.

As he said, John took 4 ETH from the capital pool and invested 20 USDT into the capital pool. After this change, the pool became 16 ETH and 100 USDT.

Suppose after this transaction, you decide to withdraw liquidity. You withdraw all liquidity from the pool and start calculating your earnings. But to your dismay, the Uniswap journey will give you less in the end than simply HODLing.

An impermanent loss of $12 occurred.

The root cause: Profits taken away by arbitrageurs

As we discussed before, constant product AMM determines the price of a specific token entirely based on the amount you want to trade. , it is more like an isolated system that is not affected by the big market. This leaves room for arbitrage, and as long as the price in the pool is different from the price outside the pool, it is up to arbitrageurs like John in our example to push the price of the token to market levels.

An interesting result is that when there is an arbitrage opportunity, Uniswap always sells tokens with a higher price in the big market relative to the pool, and buys tokens with a lower price in the big market relative to the pool. currency.

Let’s take the ETH/ USDT pool as an example again.

Obviously, for you as an LP, the movement of tokens in and out of the pool is the opposite of what you would do as an ordinary trader. Intuitively, leaving tokens in the pool is equivalent to giving up control over them and letting arbitrageurs do what they want. This creates an arbitrage profit for them and an impermanent loss for you.

You may also be interested in:

• What is AMM?
• What are liquidity and LP?