Impermanent Loss
The reduction in value experienced by liquidity providers compared to simply holding the same assets, caused by price divergence between the deposited token pair. As one token's price moves relative to the other, the AMM rebalances the pool, effectively selling the appreciating token and buying the depreciating one. The loss is 'impermanent' because it reverses if prices return to their original ratio, but becomes permanent upon withdrawal during divergence.
“If you provide ETH/USDC liquidity and ETH doubles in price, you end up with ~5.7% less value than if you had simply held both assets. If ETH 4x's, the impermanent loss grows to ~20%.”
Liquidity Pool
A collection of funds locked in a smart contract that enables decentralized trading on AMM-based exchanges. Liquidity providers (LPs) deposit paired tokens in equal value ratios and earn a share of the trading fees generated by swaps in that pool. Pools replace traditional order books in DEX architecture.
AMM (Automated Market Maker)
A type of decentralized exchange protocol that uses mathematical formulas to price assets instead of traditional order books. AMMs enable permissionless trading through liquidity pools, where prices are set algorithmically based on the ratio of tokens in the pool. The most common model is the constant product formula (x × y = k).
LP Token (Liquidity Provider Token)
A token automatically issued to liquidity providers as a receipt for their deposit in a liquidity pool. LP tokens represent proportional ownership of the pool's assets and accumulated fees. They can be redeemed at any time to withdraw the underlying tokens, and many DeFi protocols allow staking LP tokens for additional rewards.
Yield Farming
The practice of strategically deploying crypto assets across DeFi protocols to maximize returns through a combination of trading fees, token rewards, lending interest, and liquidity incentives. Yield farmers actively move capital between protocols to chase the highest yields, often compounding returns by reinvesting rewards. Higher yields typically come with higher risks, including impermanent loss, smart contract exploits, and token devaluation.