• IL is triggered whenever the price ratio of the two assets in the pool diverges.
• It is not a realized loss until the Liquidity Provider (LP) withdraws their assets.
• The loss occurs because the AMM's algorithm forces the pool to automatically sell the token that is rising in value.
• This constant rebalancing results in the LP holding fewer units of the more valuable token than if they had just held the assets.
• The primary goal of earned trading fees is to offset the exposure to Impermanent Loss.

How the Constant Product Formula Causes IL

The most common AMM formula is X *Y = K, where X and Y are the quantities of the two tokens, and K is a constant product. This formula must always be true. When the price of one token changes on an external exchange, arbitrageurs trade with the pool until the new ratio in the pool aligns with the external market. This trading action is what causes the LP's position to rebalance and incur IL.

• Scenario: An LP deposits 100 A and 100 B (Initial Ratio 1:1, Total Value $200).
• External Price Change: Token A rises to $2 per unit externally (Ratio 2:1).
• Arbitrage: Traders buy the now-undervalued A from the pool and sell B to the pool.
• Rebalance: The pool's assets are forced to shift, for instance, to 70 A and 143 B.
• Withdrawal: The LP withdraws the new amounts. If they had simply HODLed, they would have more A and less B. The difference in value is the Impermanent Loss.

Benefits of Accepting the Risk

The acceptance of Impermanent Loss is what makes the AMM model functional. LPs essentially take on this risk in exchange for the predictable flow of trading fees, which are often supplemented by "liquidity mining" rewards paid in a governance token.

• Guaranteed Liquidity: IL ensures that the pool always has assets available for trading, regardless of market direction.
• Earned Fees: LPs receive a portion of the trading fees, which acts as compensation for the risk taken.
• Liquidity Mining: Many protocols offer extra token rewards to attract liquidity and cover initial IL exposure.
• Zero-to-One Utility: The IL concept underpins the entire structural utility of DEXs powered by AMMs.
• Capital Efficiency: The risk encourages LPs to consider safer, less volatile pairs, improving overall market stability.

Challenges and Limitations of Liquidity Provision

While LPs are compensated, IL often remains the largest factor determining profitability. The risk is highly correlated with the market's volatility, meaning periods of high price change lead to higher IL.

• Unavoidable Risk: IL is a structural risk that cannot be eliminated from the constant product AMM design.
• Volatile Pairs: The loss is highest for pools containing two volatile, uncorrelated assets.
• Complexity: Accurate calculation of IL and future fee revenue is complex and requires specialized tools.
• Withdrawal Timing: An LP's biggest risk is realizing a significant loss by withdrawing during a major price divergence.
• Architectural Shifts: The development of Concentrated Liquidity addresses capital efficiency but makes managing IL even more complex for LPs.