Slippage and Price Impact in DeFi Explained
In the next two blog posts, we will walk you through one of the most important concepts of Integral, slippage and price impact. This is part 1.
Why it matters: For large and small traders alike, getting the best execution can be the difference between a winning and losing trade. In DeFi, there are still lots of opportunities to improve the trading experience.
Zoom in: One of the most frustrating parts of trading on-chain assets through decentralized exchanges is dealing with slippage and price impact. In this article, we will dive in with the whales to explore whether there is a decentralized exchange that can deliver zero slippage or price impact.
Zoom out: Slippage in DeFi is a big problem. Therefore, we built Integral SIZE is a new DEX design that eliminates price impact and slippage.
What is slippage?
Slippage is the difference between the quoted price of a trade and the final execution price. Slippage is a feature of all financial markets because there is always a delay between when a trade is "sent" by a trader to when the trade is executed on the blockchain. During this time, the market price can move from the price quoted to the trader.
Exchanges provide a quote price based on current market conditions, and the trader can set an acceptable slippage percentage they are willing to take for the trade. Anything outside of this range and the transaction will revert, canceling the trade.
Slippage can be positive or negative depending on the movements of the market. Negative slippage is when the trader gets a price worse than the quoted price, while positive slippage means the trader would get a better price.
What causes slippage?
When trading on chain with a decentralized exchange various factors influence price slippage:
- block confirmation times
- liquidity for the token pair being traded
- design of the decentralized exchange's automated market maker
Block confirmation times determine the time between when a transaction is sent and when it is confirmed. Even the fastest-confirming transactions on Ethereum take 13 seconds while a new block is mined. On other chains and L2s this can be faster, but it will change based on the gas prices a trader is willing to pay and the amount of traffic on the network.
Trading volume is also an important variable in price slippage. If a token market has a high volume of trades, the price can move between the time a trade is sent and the time it is confirmed on the blockchain.
As many altcoin traders will know, trading pairs that have low liquidity also causes high slippage. Because most decentralized exchanges use a variation of a 50/50 liquidity pool and a price curve, large trades can quickly unbalance the pool causing slippage. This is a problem for many altcoin pairs which see large price swings on trades as small as $10,000. Altcoin trades often require setting slippage to 20% or more to go through.
The design of a DEX can greatly change the slippage for trades. Different liquidity conditions, price curves, and other implementation quirks all change how slippage is realized in the market and can change the final price of a trade.
Slippage vs price impact
While the terms are often used interchangeably, slippage and price impact. You can think of slippage as the changes due to the market and price impact as the change caused just by your trade.
DeFi vs TradFi slippage
Despite explosive growth over the last few years, DeFi lacks capital-efficient trading venues and even the largest liquidity pools have yet to match the volumes of their traditional finance counterparts.
In traditional finance, almost no trader would accept a price impact of more than 5-10% outside of exceptional circumstances. In part this is because traditional markets are more mature and have more liquidity than DeFi markets. In traditional financial markets, liquidity is deeper and market makers more readily step in to enhance liquidity conditions.
In the first generation of DeFi, the focus was on decentralization above all else. This lead to a huge amount of innovation with the invention of automated market makers and various approaches to allow for permissionless liquidity deployment and trading. While the advent of decentralized trading has ushered in the first era of decentralized finance, it came at the expense of trading execution.
Traders working in DeFi have had to deal with price impact and slippage that would be unheard of in traditional financial markets. The next generation of DeFi will look to put execution on par with traditional finance. This means that platforms will need to meet the high standards of professionals from the world of TradFi while maintaining the trustless nature of DeFi that defines the space. Only by meeting or exceeding these standards will DeFi be able to attract meaningful adoption by the larger world of finance.
As DeFi expands to fill even more niches in finance, we can't expect that all projects are going to have billions of dollars sitting in their contracts. Instead, projects that are capital efficient, smart with protocol design and useful to the market will be able to leverage the TVL they do have for success.
Suprisingly, some of the largest trades have the lowest slippage.