What is Impermanent Loss (IL)?
Impermanent Loss is the loss at time T caused by a change in the value of one or more assets in the liquidity pool.
Impermanent Loss can only occur within a pool of at least two different crypto assets. This means, that by withdrawing the liquidity contributed to that pool, it is possible that the value of the funds withdrawn will be less while the amount of cryptoassets withdrawn will be more than the amount initially deposited.
In this example, we will contrast the strategies of Paul and Peter. Paul decides to keep his crypto assets in his wallet while Peter decides to use liquidity pools.
Let's assume that 1 ETH = $2,000 and 1 USDT = $1
Paul has 1 ETH which he keeps in his hardware wallet.
Peter deposits 1 ETH into a liquidity pool containing ETH and USDT. In exchange, he receives 1 LP token representing 1% of the total liquidity of the pool, which is 50 ETH and 100,000 USDT (remember that the purpose of a liquidity pool is to maintain a balance of value between the different cryptoassets that make it up).
Now let's assume that the ETH becomes more valuable and its price is now $4,000. Le cours de l'USDT, est toujours à 1$.
Paul, who keeps his ETH in his hardware wallet, still has an ETH worth $4,000.
Peter, however, still has an LP token representing 1% of the liquidity pool which itself, in order to maintain a balance, now has 37.5 ETH and 150,000 USDT.
On this basis, if Peter decided to withdraw his liquidity from the pool, he would have 0.375 ETH and 1500 USDT, a total of 0.75 ETH ($3,000).
Peter has thus lost 0.25 ETH to Paul.