Crypto Decoded

Impermanent Loss Explained: Why Liquidity Providers Can Lose Money

Impermanent loss can leave a liquidity provider worse off than simply holding the tokens. Learn how the trade-off works before chasing DeFi fees.

By Oliver Crane · June 12, 2026

DeFi can make liquidity provision sound simple: put two assets into a pool, collect trading fees, and let the smart contract do the work. The difficult part is that the pool does not just sit there. It keeps rebalancing as prices move, and that can leave a liquidity provider worse off than if they had simply held the two assets.

Reviewed by Sarah Okafor, Editor · June 12, 2026, 11:59 pm BST

In this article

The Short Version

Key Takeaways

Impermanent loss is the shortfall a liquidity provider can face when pool prices move after they add assets.
The loss comes from the pool automatically changing the mix of assets as traders use it.
Trading fees can reduce or outweigh the loss, but they do not remove the risk.
The word impermanent is misleading because the loss becomes real if the provider withdraws while the price gap remains.

Why Liquidity Pools Can Lose Value

A liquidity pool is not a savings account. It is a smart contract that holds assets so other people can trade against them. In a simple two asset pool, liquidity providers put in both sides of the pair. Traders then swap one asset for the other, and the pool changes its balances to keep the market working.

If you are new to the plumbing, start with our guide to liquidity in crypto. The key point for impermanent loss is that liquidity is useful precisely because the pool is willing to trade. That willingness creates fee income, but it also means the provider is exposed to how the two assets move against each other.

Uniswap’s support docs explain that its pools use a constant product formula. In plain English, the pool tries to keep the product of the two token balances steady as swaps happen. The formula is usually written as x multiplied by y equals k. That small formula is the reason the pool keeps changing your asset mix.

How Impermanent Loss Happens

Impermanent loss starts when the price of one asset in the pool moves away from the price at which you added liquidity. Traders and arbitrage bots respond to that price difference. They buy the cheaper side from the pool and sell into the more expensive market until the pool price moves back towards the outside market price.

That sounds efficient, and for traders it often is. For the liquidity provider, the effect is more awkward. The pool sells some of the asset that has gone up and accumulates more of the asset that has lagged behind. By the time you withdraw, you may own less of the winner and more of the weaker asset than you would have held outside the pool.

This is why impermanent loss is not the same as a normal paper loss from a falling market. Both assets can still have value. The pool can still be working. You can still have earned fees. The problem is comparison. The relevant question is not simply whether the position is worth more than before. It is whether it is worth less than the value of just holding the original assets.

Why The Word Impermanent Can Mislead

The term impermanent loss comes from the idea that the shortfall can shrink or disappear if the relative prices move back to where they were when you provided liquidity. If the price relationship returns to the starting point before you withdraw, the rebalancing effect may unwind.

That does not mean the risk is harmless. If you withdraw while the price difference remains, the loss is no longer theoretical. It is baked into the assets you receive back. The pool will return your share of its current balances, not the exact number of each token you originally deposited.

This is where a lot of DeFi marketing becomes too neat. A pool may show attractive fee income, and a dashboard may show yield, but neither figure fully explains the trade off. Our explainer on yield farming goes into that broader problem: headline returns can hide the risks that sit underneath the strategy.

Fees Do Not Automatically Solve The Problem

Liquidity providers usually receive a share of trading fees. Uniswap’s developer documentation describes fees as accruing to liquidity providers, although the exact fee structure depends on the protocol version, the pool and its settings. Fees matter because they are the compensation for taking pool risk.

But fees are not a guarantee. A busy pool with steady trading and modest price movement may produce enough fee income to make liquidity provision worthwhile for some participants. A pool with sharp price movement, thin trading, or a weak token pair may not. The loss from rebalancing can be larger than the fees collected.

There is another practical issue. In more advanced pools, especially those using concentrated liquidity, providers may choose specific price ranges. This can make capital more efficient, but it can also make the position more sensitive to price moving outside the chosen range. More control does not automatically mean less risk.

Watch Out

High displayed yield does not prove a liquidity pool is safe or profitable.
Fees, token incentives and impermanent loss need to be considered together.
Pool smart contracts, token design and market depth can all add separate risks.

A Worked Example

Imagine a simple ETH and stablecoin pool. For the example only, suppose ETH starts at 2,000 stablecoin units. You add 1 ETH and 2,000 stablecoin units, so the starting value of your position is 4,000 stablecoin units.

Now imagine ETH doubles to 4,000 stablecoin units outside the pool. If you had simply held your assets, you would have 1 ETH worth 4,000 plus 2,000 stablecoin units. That is 6,000 stablecoin units before considering any other costs.

Inside a constant product pool, traders rebalance the pool as the price changes. Using the simple x multiplied by y equals k model, your equivalent pool share might end up looking roughly like 0.707 ETH plus 2,828 stablecoin units. At the new ETH price, that is about 5,657 stablecoin units.

In this simplified example, the pool position is still worth more than the original 4,000 stablecoin units. The issue is that it is worth less than simply holding the original assets, before fees. The gap is the impermanent loss. Trading fees might reduce that gap, remove it, or fail to cover it. You do not know that from the headline yield alone.

What This Means For You

If you are only trying to understand DeFi, impermanent loss is one of the clearest examples of why crypto yield is not the same as bank interest. A bank interest rate is attached to a regulated deposit or lending product. A liquidity pool return is attached to market movement, smart contract mechanics, token risk and user activity.

If you are looking at a pool, the first question is not, “what is the yield?” It is, “what am I being paid to risk?” You need to understand what happens if one asset rises sharply, one falls sharply, trading dries up, incentives end, or the pool becomes expensive to exit. Our guide to decentralised exchanges explains why these systems work differently from platforms such as Coinbase or Binance.

The FCA’s crypto guidance is blunt that people should be prepared to lose all the money they put into crypto. That risk warning matters here. Liquidity provision can look technical and sophisticated, but it is still exposure to volatile cryptoassets.

In Plain English

Impermanent loss means the pool has quietly changed what you own.

You put in two assets. Prices move. Traders use the pool. The pool rebalances. When you come back, you may have less of the asset that rose and more of the asset that lagged. Fees may help, but they are not magic.

Do not judge a liquidity pool by the yield number alone. Ask what can happen to the assets inside it.