Impermanent loss: the hidden risk of providing liquidity in DeFi

Providing liquidity to a DeFi pool looks like a way to passively earn from other people's trading fees. But the strategy carries a subtle risk that can eat into or exceed the fees earned — impermanent loss.

Where This Loss Comes From

When you provide liquidity to, say, an ETH/USDC pair, you deposit both assets in equal value. An automated market maker keeps that ratio balanced using a formula, not a human decision. If ETH's price rises sharply, arbitrageurs will buy ETH out of the pool at its old, lower price until the pool catches up with the market — meaning that by the time you withdraw your share, you'll end up with less of the now-more-valuable ETH and more of the stable USDC than if you'd simply held both assets in your wallet.

Why It's Called "Impermanent"

The loss is called impermanent because it only exists on paper as long as you stay in the pool — if the assets' prices return to the ratio they had when you entered, the difference disappears. It only becomes a real, locked-in loss the moment you withdraw funds from the pool while the price ratio has shifted.

When the Risk Is Especially High

• Pairs of two volatile assets rather than a pair with a stablecoin — the sharper the price moves relative to each other, the higher the potential loss
• Holding a position through a strong, sustained one-directional rise or fall in one of the paired assets
• Low trading volume in the pool — the fees meant to offset the loss simply don't accumulate fast enough

What This Means in Practice

Before depositing funds into a liquidity pool, it's worth comparing the expected fee income against the likely scale of impermanent loss under different price scenarios — and honestly asking whether, in that specific situation, it wouldn't be more profitable to simply hold both assets separately.