Impermanent loss and smart-contract risk
Whoever supplies liquidity ends up holding less of whatever went up. The loss compared to simply holding grows with price divergence and isn't temporary.
In a liquidity pool, you deposit two assets in a fixed ratio so others can swap between them. In exchange, you get a share of the trading fees.
The catch: if one of the two assets rises sharply, people swap the other one for it. You end up holding more of the one that fell and less of the one that rose. Compared to simply holding, you've lost out.
The name is misleading. This loss is only temporary if prices return to their starting ratio. If they don't, and usually they don't, it's permanent.
For this to pay off, fee income has to exceed that loss. That can work out, say for two very similar assets. For sharply fluctuating pairs it often doesn't, and those are exactly the ones advertised the loudest.
In a constant-product pool, x · y stays constant, so the share amounts automatically shift as the price changes. The value gap versus simply holding equals 2·√p/(1+p) − 1, with p the ratio of the new price to the old one. Doubling one asset's price produces a shortfall of roughly 5.7 percent; quadrupling it, roughly 20 percent.
The liquidity provider's return is therefore the difference between fee income and this shortfall. Economically, the position is equivalent to selling volatility: you earn during calm periods and lose during sharp moves. This structure resembles selling options, which is why the return distribution shows many small gains and rare large losses.
Smart-contract risk adds on top and is independent of market risk. It includes bugs, manipulable price feeds, and permissions to alter the contracts after the fact. Unlike market risk, it can't be reduced by diversifying across positions, only by diversifying across independent protocols and limiting the share deployed.
Summary
- The loss versus holding is permanent if prices don't return.
- Supplying liquidity economically equals selling volatility.
- Smart-contract risk can't be diversified away, only limited.
Did you get it?
Why is the term impermanent loss misleading?
Because the loss is only temporary if prices return to their starting ratio.
What business does supplying liquidity resemble?
Selling volatility: many small gains, rare large losses.
How do you address smart-contract risk?
By diversifying across independent protocols and limiting the share deployed.