What Is Impermanent Loss Protection?

Impermanent loss is one of the most significant risks of providing liquidity to AMM pools and can make it harder for capital to come to pools. To reduce this risk, some protocols promised to pay all or part of the loss at the time of withdrawal to users who keep their liquidity in the pool for a certain period. Protection usually increases gradually over time; the compensation rate, very low in the first days, reaches full protection when the set period ends.

The best-known example of this model is Bancor. However, if compensation is paid in the protocol's newly minted own token, the mechanism has a significant weakness: when there is a sharp market-wide drop, many users withdraw at the same time, the protocol mints more tokens, the token's value falls, and the cost of the protection rises even further. Indeed, during the market turmoil of 2022, Bancor suspended its impermanent loss protection.

For this reason, in a protocol offering such protection, it matters which source the compensation is paid from, what the conditions of the protection are, and whether the protocol can change those conditions unilaterally. The protection does not eliminate the risk; it shifts part of it onto the protocol's economic soundness.