What is Impermanent Loss (IL)?

Impermanent Loss is one of the risks to which a liquidity provider is exposed by depositing two different cryptoassets. It is the shortfall that the liquidity provider may incur by depositing its assets, instead of keeping them in its portfolio. This is due to the fact that a liquidity pool maintains the balance of value between the different cryptoassets that make it up.

Here's an example of Impermanent Loss:

At start: 1 ETH = $2,000, and 1 USDT = $1

Paul keeps 1 ETH in his portfolio, i.e. $2,000.

Peter deposits 1 ETH in a liquidity pool.

This pool contains ETH and USDT. In exchange, Peter receives 1 LP token representing 1% of the total liquidity (50 ETH / 100,000 USDT).

A few weeks later: 1 ETH = $4,000, and 1 USDT = $1.

Paul still has 1 ETH in his wallet, i.e. $4,000. His capital has therefore doubled.

On the other hand, Peter's liquidity pool is rebalanced to maintain its 50% ETH / 50% USDT split.

The pool now contains 37.5 ETH and 150,000 USDT.

(As opposed to 50 ETH / 100,000 USDT initially).

As a result: if Peter withdraws his liquidity from the pool, he recovers 0.375 ETH and 1,500 USDT.
This equals 0.75 ETH, i.e. $3,000.

If Peter had kept his ETH in his wallet instead of immobilizing them in a pool, he wouldn't have lost the 0.25 ETH.

The 0.25 ETH represent the Impermanent Loss.