Impermanent loss occurs because of how automated market makers rebalance assets inside a liquidity pool when prices change. In a typical two-asset pool, liquidity providers deposit equal values of both tokens. When the market price of one token moves relative to the other, traders and arbitrageurs interact with the pool to bring its internal price in line with the broader market. This process forces the pool to automatically sell the asset that is rising in price and buy more of the asset that is falling.

As a result, liquidity providers end up holding a different asset mix than they originally deposited. If the price of one token increases significantly, the provider holds less of that appreciating asset compared to simply holding it in a wallet. The difference between the value of holding assets in the pool versus holding them outside the pool is called impermanent loss.

The loss is termed “impermanent” because it only becomes permanent if liquidity is withdrawn while prices remain diverged. If prices return to their original ratio, the loss can shrink or disappear. However, large or sustained price movements increase impermanent loss, especially in volatile pools. Trading fees and incentives can offset this effect, but they do not eliminate it. Impermanent loss is therefore a trade-off for providing liquidity, reflecting the cost of enabling continuous, permissionless trading in decentralised markets.