There is a famous quote from an American businessman Lee Lacocca; “Every business and every product have risks. You can’t get around it”. This context is an explanation of such a risk that occurs in the cryptocurrency domain. If you have already involved in virtual currencies you might have experienced a certain amount of loss when you are providing liquidity to the liquidity pool. If you are a beginner you might be curious about this “loss”. The rest of this context will provide an introduction about Impermeant Loss that could be applicable for both the above parties.
If you are providing liquidity to the Automated Market Maker (AAM) platforms, you lose a certain number of tokens compared to the amount of your deposition. You might experience a gap between your actual tokens and deposited values. This occurs when the prices of the tokens that you are depositing in AAMs change. The more it fluxgates, the more loss fluxgates. The risk of losing a certain amount of assets within the liquidity pool is known as “Impermanent Loss”
The reason to identify this as “Impermanent” is, according to the theoretical expiations, once the relative prices of the tokens return to their initial level, the loss may disappear allowing you to earn the maximum of the trading fee. But the practical scenario defers from this. Most of the time, this loss becomes permanent due to the continuous fluctuations of the values of the tokens.
But the occurrence of impermanent loss is necessarily required to keep the balance of the AAMs. In general, the prices of AAMs/Virtual currencies defer from physical exchanging markets. AAMs do not adjust this price difference automatically. This should be done by an arbitrageur. Either an arbitrageur should buy the underpriced assists or he should sell overpriced assets until the system comes to a balanced level. While this process, a certain value of the liquidity providers converts to the profit of the arbitrageur. Therefore, the liquidity providers experience this loss.
If you are expecting to avoid such losses in your investment, the most recommended method is to study and monitor the value fluctuations of liquidity pools/AAMs before providing liquidity.