What Is Impermanent Loss? The DeFi Risk Nobody Talks About

If you provide liquidity to a decentralised exchange like Uniswap, you will encounter impermanent loss. It is one of the most misunderstood risks in DeFi, and it can significantly eat into your returns.

The simple explanation

When you provide liquidity to a pool, you deposit two tokens in equal value — say £500 of ETH and £500 of USDC. The pool uses an algorithm to facilitate trades. As the price of ETH changes, the pool automatically rebalances your position. If ETH goes up, the pool sells some of your ETH for more USDC. If ETH goes down, it sells USDC for more ETH. The result is that you always end up with less of the token that increased in value than if you had just held it.

The formula

For a standard 50/50 pool, impermanent loss is calculated as: IL = 2 × √(price ratio) / (1 + price ratio) - 1. If ETH doubles in price (ratio = 2), IL is approximately 5.7%. If ETH triples (ratio = 3), IL is about 13.4%. If ETH halves (ratio = 0.5), IL is also about 5.7%.

Why it is called "impermanent"

The loss is "impermanent" because if the price returns to its original ratio, the loss disappears. However, in practice, prices rarely return to exactly the same point. And if you withdraw your liquidity while the price has diverged, the loss becomes permanent and realised.

When is it worth providing liquidity?

Impermanent loss is only one side of the equation. As a liquidity provider, you earn a share of all trading fees generated by the pool. Some pools also offer additional token rewards (liquidity mining). If the fees earned exceed the impermanent loss, you come out ahead. High-volume pools with correlated assets (like stETH/ETH or USDC/USDT) have minimal impermanent loss because the tokens trade close to a fixed ratio.

Minimising impermanent loss

Provide liquidity to pools with correlated assets. Use concentrated liquidity positions (like Uniswap V3) carefully — they amplify both fees and impermanent loss. Monitor your positions regularly and withdraw if the price diverges too far. Use our impermanent loss calculator to model scenarios before committing funds.