Impermanent Loss

Impermanent loss is the difference in value between depositing two assets into an automated market maker liquidity pool and simply holding those same two assets outside the pool.

Automated market makers, the mechanism behind most decentralized exchanges, keep a pool of two assets balanced according to a pricing formula rather than an order book. As the market price of one asset moves relative to the other, arbitrage traders buy and sell against the pool to bring its internal price back in line with the broader market — and every one of those trades adjusts the pool's mix of the two assets. The more the price ratio between the two assets diverges from where it was when you deposited, the more the pool's composition shifts away from your original deposit, and the more your withdrawal value lags behind what simply holding the two assets would have been worth. It's called "impermanent" because the loss only becomes permanent once you withdraw; if prices return to where they started, the gap closes.

This matters for anyone considering liquidity provision as a way to earn yield, since the trading fees earned from providing liquidity need to outweigh this divergence effect for the position to actually beat simply holding the assets. Pools of two assets that tend to move together, like two stablecoins, experience very little impermanent loss; pools pairing a volatile asset against a stable one can see substantial divergence during a strong trend in either direction.

Zest's impermanent loss calculator, at /tools/impermanent-loss, lets you model this trade-off for a given price scenario before committing funds to a pool, comparing the pooled outcome against simply holding.

Liquidity pools are foundational infrastructure across DeFi, including on Layer 2 networks where lower fees make smaller positions more practical, and increasingly on pools that span assets moved in via a bridge from other chains — which layers bridge risk on top of impermanent loss risk for cross-chain liquidity positions. Understanding impermanent loss before providing liquidity is less about avoiding it entirely, since it's inherent to how AMMs work, and more about sizing a position appropriately and choosing pools where expected fee income has a realistic chance of outweighing expected divergence.