When you commit your assets to a liquidity pool, you risk something known as 'impermanent loss'.
Impermanent loss is when the price of assets locked up in a liquidity pool changes after being deposited and creates an unrealized loss (in dollar terms) versus if the liquidity provider had simply held the assets in a crypto wallet.
The change occurs for two reasons and has to do with the Automated Market Maker system DeFi liquidity pools use.
- DeFi pools maintain a ratio of assets in the pool. For example, an ETH/LINK pool might fix the ratio of ETH and Link tokens in the pool at 1:50 (respectively). Meaning anyone wishing to provide liquidity would have to deposit both ether and link into the pool at that ratio.
- DeFi pools rely on arbitrage traders to align pool asset prices with the current market value, i.e., if the market price of LINK is $15 but the value of LINK in an ETH/LINK pool is $14.50, arbitrage traders will spot the discrepancy and be financially incentivized to add ETH to the pool and remove the discounted LINK.
When arbitrage traders flood the pool with one token in order to remove the discounted token –– in this example, adding ETH to take out LINK –– the ratio of coins changes. In order to regain balance, the liquidity pool automatically increases the price of the token in higher supply (LINK) and reduces the price of the token in lower supply (ETH) to encourage arbitrage traders to rebalance the pool.
Once the pool rebalances, the rise in the value of the liquidity pool is often less than the value of the assets if held by the lending protocol. That's an impermanent loss.