Automated market maker (AMM) technology has taken off in spite of one of DeFi’s dirty secrets: Users who provide liquidity to AMMs can see their staked tokens lose value compared to simply holding the tokens on their own.

This risk, known as “impermanent loss”, has prevented many mainstream and institutional users from providing liquidity, since unlike most staking products, AMMs run the risk of under-performing a basic buy-and-hold strategy.

Some users are completely unaware of the risk, others are vaguely familiar with the concept. But most people don’t really understand how and why impermanent loss occurs.

This post seeks to explain the impermanent loss in simple terms and explores potential ways to mitigate it through an AMM design that favors liquidity providers over arbitrageurs.

Simply put, the impermanent loss is the difference between holding tokens in an AMM and holding them in your wallet.

It occurs when the price of tokens inside an AMM diverges in any direction. The more divergence, the greater the impermanent loss.

Because as long as the relative prices of tokens in the AMM return to their original state when you entered the AMM, the loss disappears and you earn 100% of the trading fees.

However, this is rarely the case. More often than not, impermanent loss becomes permanent, eating into your trade income or leaving you with negative returns.

While LINK rose over 700% in the last year (in terms of USD), returns for providing liquidity to the LINK/ETH on Uniswap were down -52.67%.

To understand how impermanent loss occurs, we first need to understand how AMM pricing works and the role arbitrageurs play.

In their raw form, AMMs are disconnected from external markets. If token prices change on external markets, an AMM doesn’t automatically adjust its prices. It requires an arbitrageur to come along and buy the underpriced asset or sell the overpriced asset until prices offered by the AMM match external markets.

During this process, the profit extracted by arbitrageurs is effectively removed from the pockets of liquidity providers, resulting in the impermanent loss.

For example, consider an AMM with two assets, ETH and DAI, set at a 50/50 ratio. As shown below, a change in the price of ETH opens an opportunity for arbitrageurs to profit at the expense of liquidity providers.

Google sheet with calculations can be found here.

If you examine different price movements, you can see that even small changes in the price of ETH cause liquidity providers to suffer impermanent loss:

Clearly, this is an issue that needs to be addressed if AMMs are to achieve widespread adoption among everyday users and institutions.

If users are expected to constantly monitor and act on changes in the AMM to avoid significant losses, liquidity provision becomes a game that is reserved for only the most advanced traders (see: traditional finance).