Market Making pools hold two or more assets, and have a rebalancing algorithm to keep the ratio of asset values in the pools stable as asset prices diverge. Through this rebalancing mechanism, pools hold less of the assets whose price went up, and more of the assets whose price went down (relative to the other assets in the pool). The difference in value between the value of the assets held separately (i.e. outside of the pool) and the value of the pool is called Impermanent Loss.
Impermanent Loss increases as the prices of the assets in the pool diverge and as there is more rebalancing. Impermanent Loss decreases as the price of the assets return to the same ratio as they were when the pool was entered. There is no impermanent loss when the price ratio between the assets is the same at the time of entering and exiting the pool.
The rebalancing feature of market-making pools provides investors the opportunity to keep a balanced portfolio, but this also has an opportunity cost aspect in the form of missed opportunity to experience the upside from a specific asset gaining vs other assets in the pool.
Example:
Assume you provide two assets, ETH and USDC into a liquidity pool. The pool requires these two assets to be deposited in equal value. Assume the price of ETH is $100, so you deposit 1 ETH + 100 USDC for a total investment of $200 USD.
Consider these scenarios:
At a price of $100 per ETH there is no loss, at 0%
At a price of $200 per ETH (100% increase), there is an impermanent loss of -5.71%
At a price of $300 per ETH (200% increase), there is an impermanent loss of -13.33%
At a price of $400 per ETH (300% increase), there is an impermanent loss of -20%
At a price of $500 per ETH (400% increase), there is an impermanent loss of -25.46%
