Price slippage occurs in both centralized and decentralized exchanges, but what are the causes and risks associated with it?
Price slippage is a constant risk in trading on centralized exchanges (CEXs) and decentralized exchanges (DEXs) alike. It occurs when a trader’s order is executed at a different price than the one intended. It can happen due to high volatility, low liquidity or delays in order execution, resulting in a noticeable difference between the expected and actual transaction price.
The DeFi ecosystem prioritizes decentralization and transparency, so the price slippage problem is more prominent than on centralized platforms.
Price slippage on CEXs and DEXs
On CEXs, price slippage is caused by factors such as low liquidity, high volatility and order book depth. CEXs are platforms that connect buyers and sellers of digital assets, with order books being a key element.
An order book is a record of all buy and sell orders placed by traders for a particular cryptocurrency. It displays the quantity and price of each order, and orders are arranged by price. For example, if someone wants to buy $1,000 worth of Bitcoin BTC $20,145 and there is another trader looking to sell his Bitcoin for a similar amount, these orders will be matched in the order book. Market orders are executed immediately at the best price, while limit orders are executed at a price indicated by the trader when there is a match.
The depth of an order book is defined by the quantity of buy and sell orders at different price levels. Market depth is a key indicator of liquidity on any platform. Thus, the greater the market depth, the lower the chance of price slippage, thanks to the balance between buy and sell orders.
In reality, liquidity is not only provided by regular buyers and sellers but mainly by market makers, who place orders at both ends and profit from the bid-ask spread.
Large CEXs can boast great liquidity, which minimizes the risk of price slippage since even large orders can be fulfilled.
Since order books are managed by centralized entities, DEXs don’t have these at all. Instead, they employ the Automated Market Maker (AMM) model, which implies pre-funded pools for each cryptocurrency pair to cover both sides of trades. The liquidity pools are supplied by liquidity providers, who get incentivized to lock an equal value of both cryptocurrencies of a pair. The trading fees on the DEX are distributed to all liquidity providers, who take the role of market makers.
While there are several types of AMM models, the constant product formula is the most widespread one. Since it requires a constant balance between the pair components, a standard AMM is prone to price slippage because of the price impact, which can be affected by the liquidity pool size and the order size. When a trader places a buy or sell order, the AMM algorithm calculates the new price based on the change in the ratio of tokens in the pool. Low liquidity can lead to significant slippage, as large orders tend to cause imbalance.
Other factors leading to price slippage on AMMs relate to price volatility, Maximal Extractable Value (MEV) on Ethereum, blockchain throughput, front-running (prior knowledge) and sandwich attacks, among others.
How to fight price slippage in DeFi
Given that DEXs are more vulnerable to price slippage than CEXs, most of them integrate a feature that enables users to set the slippage tolerance percentage to limit the difference between the order price and the execution price. If the final price exceeds the limit, then the transaction is reverted. While this is a useful tool, low slippage tolerance would cause most large orders to fail, while higher tolerance can end up in an unfavorable trade.
To reduce the risk of price slippage, DEXs have to ensure high liquidity in their pools. There is no DEX capable of competing with large CEXs in terms of liquidity, but DEX aggregators can do the trick. DEX aggregators ensure a high degree of liquidity by having access to multiple DEXs at once. Features like order splitting and order routing can further reduce the risk of price slippage.
YetAnotherDeFi (YAD) is a relevant example of a DEX aggregator. YAD is a multichain swap router that aggregates liquidity across six major blockchains, including Ethereum, BSC, Polygon, Avalanche, Fantom and Optimism. The platform enables traders to swap over 3,500 tokens at the best rates and with minimal transaction fees.
YAD leverages decentralized and noncustodial swap technology that enables traders to exchange tokens with minimal risk of price slippage.
By using YAD, traders can also reduce the risk of front-running, which happens when malicious actors exploit a blockchain’s mempool to get prior knowledge of the trading activity.
Unlike dark pools, which split large orders and mix them, YAD is decentralized and transparent, resulting in unmatched security for traders.
The bottom line
Price slippage is an inevitable factor for DeFi. It is one of the main drawbacks of the AMM model, decentralization and blockchain transparency. Traders should do their due diligence before selecting a DEX and employ all available tools to reduce the risk of price slippage and related losses.
DEX aggregators integrate all the available tools to reduce negative slippage and allow users to automate the trading process while keeping it transparent, decentralized and secure.
Learn more about Yad Finance
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