Price Impact vs. Price Slippage in Liquidity Pools

Price Impact vs. Price Slippage in Liquidity Pools


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Price Impact vs. Price Slippage in Liquidity Pools
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Price impact and price slippage have always been a point of argument for DeFi users and experts. Why these two, you may ask. It’s pretty simple: they are similar in how they cause turbulence in a trader’s doings in liquidity pools (trades to be specific!). 

A general rule of thumb in a liquidity pool dictates the presence of a “constant” or a “formula,” which underlines the ratio between token pairs (USDC/MATIC, for example). That means that each token’s value in a pool should always stay at a specific ratio with respect to its counterpart (more on that below).

Before we get down to “Price Impact vs. Price Slippage” and the nature of how constants (ratio balance) work, let’s first get the basic introductions out of the way.

What’s Price Impact on Liquidity Pools

First, we need an example: imagine an “X token”  joined with a “Y token” to form an XY liquidity pool, usually one being a stablecoin. Farmers come in, invest their X & Y tokens, and the liquidity pool becomes a market for X & Y buys and sells. 

Liquidity pools usually abide by the constant X*Y=K (eventually leading to a 50:50 distribution of each value worth in the pool) rule, which saves them from descending into complete anarchy. This hard-encoded smart contract regulates and oversees the “value balance” after trades transpire. 

By this rule – if nothing scandalous is happening – each token’s value in a pool equals its pair, which is regularly autotuned by the constant we talked about before. 

But, this is a trading ground, a market. The supply/demand rule still holds here, like in any normal market. And that’s when price impact happens. Say someone takes out one commodity (X or Y tokens) or brings them in, and the perfect constant becomes unstable. That’s when we’re experiencing price impact in a liquidity pool.

Take a trader who comes along and wants to buy 1,000 dollars worth of X tokens. As they take out their order, the number of X tokens in the pool decreases, subsequently increasing the value of the X tokens remaining to other traders.

But, How?

As soon as X tokens get dragged out of the AMM, the smart contract kicks in to readjust the ratio and uphold the constant. There are fewer X tokens in the market, resulting in more Y tokens. The simple supply/demand tells us that now, X tokens are more valuable (in fewer numbers), and Y tokens are worth less (although in larger numbers). 

X: Numbers ⬇️ – Value 🔼

Y: Numbers 🔼 – Value ⬇️

And this way, with some maths done in the algorithm (smart contract), the total value of each token balances itself out in contrast to the other.

What’s Price Slippage

Price Slippage operates as a safety net, as a “get-out” option in the form of a box popping up while conducting a trade. 

In liquidity pools, and partially due to price impact, the prospect of “you sneeze, you lose” has risen. You see, in these partially close-off markets – investment in tokens is however available by farming –  token pair values constantly shift, as explained above. This causes quoted prices to slip to other numbers — and yes, it’s not always a negative impact.

However, in most cases, it could cause some extra money to finalize a trade. So, before somebody invests in buying, the price slippage option swoops in, showing traders a “Safety Net” and letting them choose how much loss (slippage) they are willing to accept for the aforementioned trade.

But what causes price slippage in the XY AMM? Here’s what we think:

  • Block Confirmation Times

From setting the order until it is transmitted to the chain and mined, it takes a while. During this time, other trade and price impact effects may cause price slippages.

  • Volume

Liquidity pools with lower TVL (total value locked) are more fragile to price impact, thus, making them weak against price slippage. However, price slippage isn’t always a direct consequence of price impact. So, keep that in mind.

Price Impact vs. Price Slippage

While both impact the X and Y tokens prices and are an annoyance to traders of a pool, they don’t do it similarly.

Price Impact is caused by the actions of a trader, an external wave. With every token taken out or tossed into a liquidity pool by traders, X and Y token prices go up and down, which can be considered an external effect.

Price Slippage, on the other hand, shows face as the aftermath of broader market movements. Multiple factors, as explained above, contribute to the quoted prices and final prices differing and creating slippages.

It’s funny and safe to say that in lower TVL pools, “one man’s price impact is another’s price slippage” sometimes! 

Take Away

There’s no way around these numbers, these impacts, and slippages. However, there are some remediations to offset their price-shifting effects.

When choosing a liquidity pool for trades, and if you’re worried about the Price Impact and Price Slippage, try pools with higher volumes since they’re more stable. Also, make sure to check DeFi projects before you dive nose-first into their pools. You can read here and learn how to identify the good ones from the scandalous ones, which ones are legit, and which tokens are scams.

Also, before launching new pools as a DEX, CrowdSwap through everything in its power to lower the price impacts. We also only lean towards projects with reliable and transparent smart contracts and details.

Additionally, we ensure that new markets start with relatively reasonable TVLs initially, so price slippage and other internal conflicts don’t cost you that much!

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