Have you ever noticed that the amount of tokens you've provided to a liquidity pool have been reduced over time? This is due to a concept known as "impermanent loss".
Impermanent loss is the temporary reduction of capital caused by volatility between tokens provided to the pool.
If the tokens return to their original value before liquidity is withdrawn, then the loss is no longer present.
When providing liquidity to a 1inch liquidity pool, a liquidity provider (LP) supplies an equal (50/50) ratio of tokens, denominated in USD. If the external market price of either of the tokens changes externally, an arbitrage trader can take advantage of the difference by buying or selling that token from/to the 1inch pool. This buying/selling activity disrupts the previously equal 50/50 supply of the pool, causing an imbalance at the expense of the liquidity providers. If the liquidity is withdrawn by the LP at this point in time, the loss becomes permanent. However, if the LP leaves their liquidity in the pool, the rate could eventually return to what it was at the time of deposit, erasing any losses.
Here is a hypothetical example of impermanent loss in a 1inch-USDC pool (without taking trading fees into account):
Initial Liquidity Provided
Price: $100 per 1inch
Price: $1 per USDC
Value Provided: $100 USD
Value: $100 USD
Total deposit into the pool = $200
Let's pretend that the total amount of tokens you deposited is only 10% of the entire pool. This makes the total pool liquidity equal to 10,000 USD (10 1inch and 1,000 USDC).
Now, imagine the price of 1inch increases to $400 per 1inch externally on a centralized exchange; meanwhile, the price temporarily remains constant in the pool. This price difference creates an arbitrage opportunity between the 1inch-USDC pool and the centralized exchange. With this, an arbitrage trader swoops in to buy the cheaper 1inch from the pool (to go sell elsewhere at the higher price) until the price of the pool matches that of the external exchange rate. To accomplish this though, they must pay USDC to the pool in order to obtain the “cheaper” 1inch tokens.
This arbitrage activity causes the ratio of 1inch to USDC in the pool to change. Since this pool is regulated by the formula x*y=k, the total liquidity in the pool must remain constant, despite fluctuations in the supply of underlying tokens. Now that this arbitrage has taken place, the pool’s total supply has changed to 5 1inch and 2,000 USDC. Since your provided liquidity only represents 10% of that total, you now have 0.5 1inch and 200 USDC.
At first glance, you might think that you made a nice profit from this volatility; however, when comparing this amount to what would have been made by holding the assets outside of the pool, you can see that the profit would have been even higher by simply holding.
Here is a breakdown of the before and after, along with the amount that would have been made by holding the tokens outside of the pool:
This difference between the amount that would have been made (or lost) vs holding is what defines impermanent loss. Similar to the example above, if the price of one of the tokens decreases in relation to the other, then the loss from providing liquidity to the pool would be greater than if you had simply held the tokens.
Again, this example does not take trading fees (rewards) into account. Depending on the volume of the pool, the rewards earned might negate the losses, and ultimately give more profit for providing liquidity. In addition to the liquidity rewards, some pools also have associated Liquidity Mining (Yield Farming) incentive programs, which further help to offset any impermanent loss for liquidity providers.