Impermanent loss while providing liquidity explained.

This was one of the things I had the most trouble understanding as an early crypto enthusiast because I thought I understood it but I didn't really. So let me attempt to explain it in the easiest possible way.

Let's say you are providing liquidity for ETH/BNB pairing.

You have 3 options,

Add ETH only to the liquidity pool

Add BNB only.

Add both ETH and BNB

For simplicity lets assume 1 ETH ($4000) = 10 BNB ($400 *10)

NOW, you add 1 ETH to the pool.

Half of it will be automatically converted to BNB at the time of transaction.

So you will have 0.5 ETH and 5 BNB in the pool, at the start of the contract/transaction.

Now, lets say ETH L2 is announced and ETH goes up 2x to $8000 each. Meanwhile, BNB has not moved as much, and is still at the original price of $400.

Ok, so this is the important part. If you had just held your 1 ETH which has gone from $4000 to $8000, your gain would have been $4000.

However, since your 1ETH got converted half to BNB at the start, to provide a 50/50 ratio, without any further balancing (coming later), you had 0.5 ETH (currently worth 8000 x 0.5 = $4000) and 5 BNB (currently worth 400 x5 = $2000)

So, if you had held on to your original 1 ETH it would be worth $8000, but now you only have 0.5 ETH and 5 BNB totalling $6000.

To further complicate things, any liquidity pool tries to maintain a 50/50 ratio. So, instead of getting back 0.5 ETH and 5 BNB, that we had originally put in, the pool will have rebalanced to something like 0.375 ETH ($3,000) and 7.5 BNB ($3000) to keep things at a 50/50 ratio.

So, when you redeem your tokens, you will get back 0.375 ETH and 7.5 BNB. After putting in $4000 you are getting back $6000, since ETH went up in value. But if you had held onto your 1 ETH and did nothing you would have $8000.

Now, the question is, why would anyone add liquidity? The simple answer is you get a certain APY%, so if ETH had not 2x'd in value, or if ETH and BNB had both 2x'd, you would have made 20% or 30% APY for providing liquidity.