Impermanent loss is a concept that is commonly associated with liquidity provision in automated market makers (AMMs) in decentralized finance (DeFi). It refers to the temporary loss of value that liquidity providers may experience when they supply two assets to a liquidity pool and the price ratio of those assets changes.
In an AMM, liquidity providers supply equal amounts of two assets to create a trading pair. These assets are then used to facilitate trades between buyers and sellers. The price of each asset is determined by the balance of the assets in the pool, with the price ratio being constantly adjusted as traders buy or sell either asset.
If the price ratio of the two assets changes significantly, liquidity providers may experience impermanent loss. This occurs because the value of the assets they supplied has changed relative to each other, and the liquidity provider now has a different balance of each asset than they started with.
For example, if a liquidity provider supplies equal amounts of ETH and USDT to a liquidity pool, and the price of ETH increases significantly relative to USDT, the liquidity provider may end up with a higher balance of ETH and a lower balance of USDT than they started with. This means that if they were to withdraw their assets from the pool at this point, they would have less USDT than they originally supplied, even if the overall value of the pool had increased.
Impermanent loss is considered "impermanent" because it only affects liquidity providers who withdraw their assets from the pool before the price ratio of the assets returns to its original value. If the price ratio returns to its original value, the liquidity provider can withdraw their assets without experiencing impermanent loss. However, if the price ratio continues to move away from its original value, the liquidity provider may experience permanent loss.