What is impermanent loss for beginners
Impermanent loss explained in simple words
How do we define impermanent loss?
This idea represents the temporary loss of a portion of the liquid assets controlled.
This situation happens in liquidity pools where the liquidity provider is required to contribute proportionate quantities of two separate tokens.
If one of the tokens is more popular, the ratio of the two assets in the pool changes.
If the provider withdraws their assets from the liquidity pool immediately, they risk not retrieving the complete amount and in the proportion in which they placed it.
A real-world example of impermanent loss.
A person contributes 1 BNB and 42 CAKE in a liquidity pool at a 50/50 split to maintain the finances of an AMM.
The deposited token quantities must be comparable in value.
In the aforementioned scenario:
Assume that the current monetary worth of person’s deposit is $200.
If the total in that pool is 100 BNB and 4200 CAKE, then the person owns 10% of the fund and the overall liquidity is $5500.
What causes impermanent loss?
Assume that the price of BNB rises to 600 CAKE in this situation.
If this occurs, arbitrage trading techniques will add CAKE to the pool while removing BNB until the ratio matches the current price.
Because AMMs do not use order books, the price of the assets is determined by their pool ratio.
In summary, if the fund’s liquidity remains constant (5500), the asset ratio changes.
Conclusions
The loss was not significant because the original deposit was modest.
In other cases, the temporary loss may result in the loss of a substantial portion of the initial deposit.
The trading fees that the supplier would have earned are entirely ignored in our case.
In many circumstances, fees generated can offset losses and make providing liquidity viable.
Before adding liquidity to a DeFi protocol, it is critical to understand the concept.
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