You deposit two tokens into a liquidity pool, watch the APY tick upward, and assume you're earning. Then you withdraw and end up with less than if you'd just held the tokens in your wallet. That gap has a name: impermanent loss.
What Actually Happens Inside a Liquidity Pool
A liquidity pool is a smart contract holding two tokens in a roughly equal ratio — say, ETH and USDC. When you add funds, you become a liquidity provider (LP) and earn a share of the trading fees generated when other users swap between those two tokens.
The catch: the pool automatically rebalances itself as prices shift. If ETH rises sharply, the pool sells some of your ETH to buy more USDC to keep the ratio balanced. You end up holding less of the token that went up and more of the one that didn't. Compared to simply holding both tokens in your wallet, you come out behind. That difference is impermanent loss.
The word "impermanent" is a little misleading. The loss only disappears entirely if prices return to exactly where they were when you deposited. In practice, that often doesn't happen.
When It Matters Most — and Least
Impermanent loss hits hardest when the two tokens in a pool move in very different directions. A pool pairing a volatile token against a stablecoin (a token designed to hold a fixed value, like $1) is the classic high-risk setup. If the volatile token doubles in price, your pool position significantly underperforms just holding the tokens.
It matters far less — sometimes almost not at all — in stablecoin-to-stablecoin pools, where both tokens are designed to stay near the same value. A pool of USDC and USDT, for example, sees almost no price divergence, so impermanent loss stays tiny.
The fee income from a busy pool can offset impermanent loss, but there's no guarantee it will. APY (Annual Percentage Yield) figures shown on pool listings usually reflect fees and reward tokens — they do not subtract the impermanent loss you might experience.
Before comparing any liquidity pool yield, ask yourself: how volatile are the two tokens relative to each other? That one question does more work than the APY number alone. The comparison table can help you see pool types side by side — just make sure you're looking beyond the headline rate.