Impermanent Loss Comes From How Pools Rebalance

Impermanent loss is the shortfall between the value of your pool share and the value of simply holding the same tokens, caused by their prices moving apart. A pool changes the amounts of each token it holds as traders buy and sell. If one token rises relative to the other, that rebalancing can leave a liquidity provider with less of the rising token than they would have held outside the pool.

What causes impermanent loss?

In a constant-product pool, the smart contract keeps the product of the two token reserves roughly constant as trades happen. If a trader buys one token, they put the other into the pool; the changing reserve ratio sets the next price. Arbitrageurs trade when the pool price differs enough from the wider market price, pushing it back towards that market price.

That process changes the pool’s inventory. When one asset becomes more valuable, arbitrage tends to remove it from the pool and add more of the other asset. The liquidity provider’s share therefore shifts towards the asset that has fallen in relative value. Impermanent loss measures the difference from holding the original quantities, valued at current prices. It is a comparison, not necessarily a loss in dollar terms: the pool share can still be worth more than the initial deposit.

Think of the pool as an automatic exchange counter that keeps adjusting its stock to attract trades. The comparison becomes a loss when that changing stock is worth less than the untouched pair would be. For a look at how pool design changes the trading range and exposure, see this Blackhole Swap pool comparison.

When does impermanent loss become permanent?

The gap is measured against holding the tokens at the same moment. If their relative prices return to the ratio they had when liquidity was added, the pool’s token mix may also return close to its starting mix, shrinking the gap. The name “impermanent” describes that possibility; it does not mean the position will recover.

Withdrawing converts the provider’s pool share into the tokens currently held for that share. If the prices have diverged, the provider exits with a different mix from the deposit. The comparison with holding is then fixed for that withdrawal. Even without withdrawing, the value gap still matters: the provider could have removed liquidity at that point and held those tokens instead.

The key variable is relative price movement, not whether both tokens rose or fell against dollars. Two assets that move together may leave the pool mix more stable. A sharp divergence tends to create a larger gap. Concentrated liquidity adds another factor: a provider chooses a price range, and outside that range the position can become one-sided and stop earning trading fees until prices return or the provider adjusts the range.

Can pool fees offset impermanent loss?

Yes, fees can offset the gap if the provider’s share of trading fees is greater than the impermanent loss and other costs over the same period. Traders pay fees when they swap; the pool allocates the relevant portion to liquidity providers according to the pool’s rules and their share of active liquidity. Fees accumulate in the position or are otherwise credited, depending on the protocol.

But fee income is uncertain. It depends on trading volume, the pool’s fee rate, how much liquidity competes for that volume, and—where liquidity is concentrated—whether the position remains in range. Impermanent loss depends on the path and final relative prices. A pool with busy trading can still leave a provider behind if the assets diverge enough, and a quiet pool can collect too little to make up the difference.

Before adding liquidity, compare the position with holding the same assets, and account for costs such as transaction fees and any costs of managing a range. The useful questions are:

• How volatile are the two assets relative to each other?
• How much trading volume reaches this pool, and how is the fee divided?
• What share of that volume is likely to pass through your liquidity?
• Will you need to adjust or withdraw the position, and what will that cost?

There is no fee level that guarantees protection from impermanent loss. Treat fees as compensation that may cover the rebalancing shortfall, not as a promise of profit. For most providers, a simple pool with assets they are willing to hold is easier to assess than a narrow concentrated range whose fee income depends on active management.