What is impermanent loss in cryptocurrency?

What is impermanent loss?

Impermanent loss occurs when the price of the crypto assets in a liquidity pool change relative to each other. This means that the balance of assets within the pool will shift in favor of the token whose price fell, reducing the total value of your position.

How do liquidity pools work?

To better understand how impermanent loss works, let's walk through the basics of how liquidity functions in both centralized and decentralized exchanges.

Where does liquidity come from in a centralized exchange?

In a traditional exchange, centralized players like Coinbase provide the liquidity needed to execute trades. For example, if you want to trade DAI for ETH on Coinbase, Coinbase will sell you ETH from its own inventory.

Where does liquidity come from in a decentralized exchange?

Decentralized protocols do not rely on centralized market makers. Instead, protocols like Uniswap rely on liquidity pools, where users can contribute their own cryptocurrency that can be used as liquidity in trades.

Most liquidity pools allow users to deposit two or more crypto assets. In exchange, liquidity providers receive transaction fees from swaps facilitated by the liquidity pools.

For example, if you own ETH and USDC, you can deposit both into a liquidity pool where investors can swap ETH for USDC and vice versa. In return, you'll receive a share of the transaction fees.

How do liquidity pools determine the mix of different assets?

Liquidity pools typically use the following formula to determine the total amount of different assets contained within the pools.

X*Y=K

In this case, X is the total reserve (amount) of the first token, Y is the total reserve (amount) of the second token, and K is a constant value.

As a result, the 'mix' of assets contained within the liquidity pool can change drastically based on how the price of each asset changes.

Impermanent loss example

Let's take a look at an example to better understand how impermanent loss works.

While Jonathan did make a profit, his assets would have been worth $1,500 had he simply held onto his cryptocurrency ($1,000 of ETH and $500 of USDC). This $200 difference between his potential and realized profits is what we would call 'impermanent loss'.

It's important to remember that this is a simplified example. We did not account for the transaction fees that Jonathan could potentially earn for depositing his cryptocurrency in a liquidity pool.

Can you recover from impermanent loss?

It is possible to recover from impermanent loss if the ratio of the asset values in the liquidity pools returns to previous levels. However, it's not guaranteed that two uncorrelated assets will return to previous levels after a large change in price.

How does impermanent loss happen?

Impermanent loss happens when there is volatility in crypto prices. When cryptocurrencies change in price relative to each other, the balance of assets in a liquidity pool changes as traders take advantage of the arbitrage opportunity, causing impermanent loss.

How to calculate impermanent loss

To estimate your impermanent loss, find the current value of your initial deposit. Next, find the current value of your portion of the liquidity pool. The difference between these two values is your impermanent loss.

Here's a formula you can use for calculating impermanent loss.

Current value of initial deposit - current value of your portion of the staking pool = Impermanent Loss

How risky is impermanent loss?

Impermanent loss is a risk to consider any time you deposit cryptocurrency in a liquidity pool.

Analytics data from 2025 shows that over half of Uniswap V3 liquidity providers in volatile token pairs lost money once impermanent loss outpaced their fee income. On average, volatile-pair positions saw impermanent losses of 11–17% annually. Stablecoin pools, where both assets track the same price, averaged just 1.8–3.4%.

In addition, it's important to remember that the cryptocurrency market is volatile and any exposure can carry risk.

How do you avoid impermanent loss?

Unfortunately, there's no way to completely avoid impermanent loss when using DeFi protocols. However, there are steps you can take to mitigate the possibility.

Impermanent loss is more likely to occur if you deposit volatile token pairs. It's less likely to occur if you deposit cryptocurrencies that are highly correlated in price with one another, such as two stablecoins.

Some protocols such as Curve offer liquidity pools of similarly behaving assets to minimize the risk of impermanent loss.

How has DeFi changed the impermanent loss picture?

The liquidity pool landscape has shifted significantly since the basic constant-product model was introduced. Two developments are especially relevant if you're thinking about providing liquidity today.

Concentrated liquidity (Uniswap V3). Uniswap V3 introduced concentrated liquidity. LPs choose a specific price range within which they provide liquidity. This increases capital efficiency, but it amplifies impermanent loss. When the price of an asset moves outside your chosen range, your position stops earning fees and is fully converted into the underperforming token. Research by Bancor and IntoTheBlock found that over 51% of Uniswap V3 liquidity providers in volatile pairs were unprofitable as a result.

Uniswap V4 hooks (launched January 2025). Uniswap V4 introduced "hooks," which are custom smart contracts that attach to individual pools. Developers can use hooks to implement dynamic fee schedules that increase during high-volatility periods, partially offsetting impermanent loss with higher fee income. The Uniswap Foundation launched a V4 Hooks Marketplace in April 2026 with $500 million in liquidity incentives.

Active liquidity managers. Platforms like Gamma Strategies and Arrakis Finance automatically rebalance concentrated liquidity positions on behalf of LPs, keeping positions in range and reducing the cost of sitting outside your price band.

Remember, even with these tools, impermanent loss isn't eliminated. It's managed.

Are there tax implications for providing liquidity?

Yes. Providing liquidity in a DeFi pool involves multiple taxable events, and most of them happen before you ever see a return.

Depositing tokens. Many tax professionals treat depositing crypto into a liquidity pool as a taxable disposal of your original tokens, since you're exchanging them for LP tokens. That means you may owe capital gains or losses at the time of deposit.

Withdrawing. When you redeem your LP tokens for the underlying assets, that's another taxable event.

Impermanent loss and taxes. The IRS has not issued specific guidance on impermanent loss as a standalone item. In practice, impermanent loss is folded into your overall gain or loss when you exit the pool. It lowers your exit proceeds relative to a simple hold, which reduces your taxable gain (or increases your loss).

Tracking cost basis across multiple liquidity pool entries and exits is complicated. Crypto tax software like CoinLedger can automatically track your DeFi activity and calculate your gains and losses.

For a broader look at how crypto activities are taxed, see our Ultimate Crypto Tax Guide.

If you have complex DeFi positions, it's worth talking to a tax professional.

Should I provide liquidity?

Providing liquidity can generate passive income from transaction fees. Whether it makes sense for you depends on a few factors.

Lower-risk situations:

• You're depositing into a stablecoin pool (e.g., USDC/USDT) where both assets track the same price
• You have a long time horizon and plan to hold through short-term price swings
• You're actively managing your position or using an automated liquidity management platform

Higher-risk situations:

• You're depositing a volatile token pair (e.g., ETH and a small-cap token)
• You're taking a short-term position and can't monitor the pool regularly
• You're using Uniswap V3 concentrated liquidity with a narrow price range

Before committing, model your expected fee income against your estimated impermanent loss exposure. The math doesn't always favor the LP, especially in volatile markets.