The term "impermanent loss" for cryptocurrency liquidity pools refers to when a token's price changes after depositing it there.

It is strongly tied to temporary loss to engage in yield farming, where you give your tokens to receive incentives. It differs from staking, though, because, with staking, investors must put money into the network to validate blocks and transactions to get rewards.

Contrarily, yield farming means lending your assets to a liquidity pool or acting as a liquidity provider. The incentives differ depending on the protocol. Offering liquidity entails risks, including control, liquidation, and pricing threats, even if it is more profitable to grow yields than to keep onto them.

The liquidity pool's size and the quantity of tokens it contains to determine the risk of temporary loss. The token is paired with another token, often a stablecoin like Tether and Ethereum-based tokens such as Ether (ETH). Stablecoins and other assets with a limited price range will make pools less susceptible to transient losses. Because of this, stablecoin reduces the danger of temporary loss for liquidity providers.

Why then do liquidity sources on AMMs continue to offer liquidity, given that they are susceptible to more losses? It's because trading commissions can make up the short-term loss. Pools on Uniswap, which are particularly sensitive to short-term losses, might be lucrative owing to trading costs.

Impermanent loss protection

Liquidity providers are covered by Impermanent Loss Protection (ILP), a sort of insurance against unforeseen losses. This insurance is a contingency plan for any type of eventualities that results into loss.

On conventional AMMs, liquidity provisioning is beneficial only if the advantages of farming outweigh the cost of momentary loss. But if the liquidity issuers lose money, they can use ILP to shield themselves from the temporary loss.

Staking tokens on a farm is required to activate ILP. To further understand how ILP functions, let's take the Bancor Network as an example. When a user adds money, Bancor's insurance coverage expands by 1 percent each day the investment is active, finally reaching its maximum range in 100 days.

The procedure provides coverage at the time of withdrawal for any transient loss that occurred within the first 100 days. However, withdrawals made prior to the 100-day maturity are only eligible for half IL compensation. For example, withdrawals after 30 days in the pool are compensated for any short-term losses at a rate of 40%.

There is no IL compensation for stakes withdrawn during the first 30 days; the LP is still responsible for the same IL they would have incurred in a traditional AMM.

 

What causes impermanent loss?

IL would result from the discrepancy between the liquidity pool tokens' value and the underlying tokens' hypothetical value if they weren't paired.

Let's examine a fictitious circumstance to discover how impermanent/temporary loss manifests itself. Let's say someone with 20 ETH wishes to contribute to a pool that has a 50/50 ETH/USDT split. In this case, they will need to invest 20 ETH and 20,000 USDT (assumed 1 ETH = 1,000 USDT).