Impermanent loss stems from the background of liquidity pools, where users contribute tokens to facilitate decentralized trading of tokens. Here are some more in-depth examples:
Asset Price Ratio
Impermanent loss occurs when the relative prices of the two tokens (LP pair) in a liquidity pool change over time. Specifically, it is driven by the disparity between the external market price of an asset and its price within the liquidity pool.
(Visual graph here)
Rebalancing Mechanism
Liquidity pools are designed to maintain a constant ratio between the two tokens, known as LPs or Liquidity Pairs. When a user interacts with the pool by trading one token for another, the pool rebalances itself automatically and gives a changing variable rate on the transaction fee and liquidity pool return liquidity fee rate.
NOTE: Impermanent loss is a measure of the difference between the theoretical returns of holding/locking tokens versus the actual returns from providing liquidity to a pool. It arises because the pool's rebalancing mechanism can lead to scenarios where the value of LPs provided as liquidity decreases in comparison to simply holding those assets. The extent of impermanent loss depends on the magnitude and change of price in the external market.
The greater the liquidity pool value fluctuations = the higher the potential for impermanent loss.
Compensatory Mechanisms
In some instances, some DeFi platforms deploy mechanisms to compensate liquidity providers for impermanent loss through additional tokens or extended earnings. However, these mechanisms vary and are not guaranteed.
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