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Definition divergence lossIL

Impermanent Loss

The shortfall a pool depositor ends up with compared with keeping the two assets outside the pool, caused by their prices diverging.

When one asset in a pool moves relative to the other, arbitrage traders rebalance the pool by taking out the asset that rose and adding the one that fell, so the depositor ends up with proportionally more of the weaker asset. The gap against simply keeping both assets separately grows with the size of the divergence and is symmetric, appearing whichever asset moves. It is called impermanent because it reverses if relative prices return to where they started, but it becomes permanent the moment the position is withdrawn. Accumulated swap fees and any incentive rewards can offset it, which is why divergence loss must always be assessed net of fees rather than on its own.

In practice

A pool holding two stablecoins that both track the same currency shows almost no divergence loss, while a pool pairing a volatile asset with a stablecoin can show a substantial one.

The common misunderstanding

The name is misleading: the loss becomes permanent at withdrawal, and only fee income earned in the meantime can make up for it.

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Related terms

Automated Market Maker A smart contract that prices trades from a formula and a pool of assets, so no other trader needs…
Concentrated Liquidity A pool design that lets a depositor commit funds only within a chosen price range, so the same…
Constant Product Formula The rule x times y equals k, which sets a pool's price by keeping the product of its two balances…
Liquidity Pool A shared pot of two or more assets locked in a smart contract that traders trade against and…
Liquidity Provider Someone who deposits assets into a pool so that others can trade against them, receiving a share of…
Yield Farming Moving assets between DeFi protocols to collect the trading fees, interest, and token rewards that…
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