What is Slippage in Crypto? Learn How to Reduce Its Impact

Blockchain technology and the Web3 ecosystem have drastically reshaped financial systems, particularly how assets are traded. One of the most fundamental changes is how crypto asset trading happens on-chain compared to classical trading, like in the stock market.

Traditional stock markets execute trades through an order book system, where buyers and sellers must be online simultaneously for their trades to match. This is necessary because an order book records the bids and asks in a real-time ledger. The system waits for the highest bid to meet the lowest ask, which results in a complete trade. This process requires both parties to be "live" in the market for the order book to match and settle their trades.

Furthermore, the price discovery of an asset in the stock market depends on the collective perceptions of individual traders about the asset's value. Buyers and sellers place bids and ask based on their expectations of an asset's future price. This creates a dynamic where the market price is continually shaped by supply, demand, and the subjective valuations of numerous traders, reflecting overall market sentiment.

Introduction of Liquidity Pools

Decentralized exchanges (DEXs) introduced a novel market structure that replaced the order book matching system with liquidity pools, fundamentally transforming price discovery and trading dynamics. Instead of relying on counterparties being present simultaneously, automated market makers (AMMs) had traders exchange tokens in liquidity pools, where the price discovery was a function of relative liquidity of the assets in the pool rather than individual traders' perceptions.

In this liquidity-centric model, the price of an asset is determined by an algorithm based on the available liquidity in the pool. For example, when one asset in the pool is bought, its quantity decreases while the other asset increases, causing an automatic adjustment in the price ratio between the two. This allows traders to buy or sell assets without needing another party to be online, removing the liveness requirement of traditional markets.

New Trading Variables

The price of assets in classical trading markets could move according to the depth of the market, which is a spread of bid and ask orders traders have placed in the market. The market depth is essential to estimate if the exchange could fill one's order at the expected price. Similarly, DEXs and AMMs introduced a new variable known as slippage that dictates if one's order in a liquidity pool is fulfilled at the expected price.

Understanding slippage is essential to using liquidity pools effectively. The liquidity in DEXs is generally significantly lower than the depth in the stock markets, which accentuates their impact on the trading experience. This article will answer what is slippage in crypto and help you use liquidity pools effectively.

Background: Understanding Liquidity Pools

Understanding how liquidity pools function is crucial for grasping the concept of slippage in decentralized exchanges (DEXs). Most liquidity pool-based DEXs, such as Uniswap, operate using a variation of the constant product formula x*y=k, pioneered by the Uniswap V2 protocol. This formula maintains a balance between two assets in a liquidity pool, ensuring that the product of their reserves (x and y) remains constant (k) after every trade.

The logic behind the constant product formula creates a price curve for each asset pair in the pool. As traders exchange tokens, the asset pair's relative liquidity shifts, causing each asset's price to changes in real time. For example, if a user buys a significant amount of one token from the pool, its price will increase relative to the other token, following the formula's algorithm. This dynamic ensures that the larger the trade, the more the price will deviate from its current value.

Since a liquidity pool allows traders to exchange tokens at any point along the price curve, liquidity gets spread across the curve, which means it is available at various price points. Unlike traditional order book systems, where liquidity can be concentrated at specific prices, liquidity pools distribute it more thinly across the entire curve.

This structure becomes particularly important when assets are trading within a tight price range. Even small trades can cause noticeable movements along the price curve, leading to price deviations as the exchange is between processing an order. In such cases, the order might not fully execute at the expected price because the trade impacts the asset's available liquidity, pushing the price further along the curve.

What is Slippage?

Slippage refers to the difference between the expected price of a trade and the actual price at which the trade gets executed by the automated market maker (AMM) protocol. In the context of decentralized exchanges (DEXs), slippage occurs when the price of an asset moves between the time a trade is initiated and when it is executed on-chain.

As explained in the previous section, the price of an asset in a liquidity pool is determined by the constant product formula, which balances the ratio of assets in the pool. However, when trading volume increases, the liquidity within the pool can become constrained. This often leads to rapid price fluctuations as multiple trades are executed simultaneously.

In such cases, the price may have shifted by the time a trader finalizes a transaction and the smart contract processes it on-chain. This price change results from other trades impacting the liquidity pool, causing the final price to differ from the expected price when the trade was initiated. Slippage happens when the price curve moves between when the trade is confirmed and when the smart contract is executed.

Slippage occurs primarily because the price curve in an AMM is continuously adjusted as each trade is processed. If other transactions are executed just before or simultaneously with yours, they can shift the price curve, affecting your trade. This is especially pronounced during periods of high market activity or in liquidity pools with limited assets.

What Causes Slippage

Several factors contribute to slippage in AMM protocols:

1. Insufficient Pool Liquidity: If a liquidity pool does not have a substantial reserve of assets, even small trades can cause significant price movements. In such low-liquidity pools, traders are more likely to experience slippage since their trades impact the available reserves and dramatically alter the price curve.
2. Volatile Market: In highly volatile markets, prices fluctuate rapidly. As a result, the time it takes to execute a trade on-chain might lead to a different price than expected. Price volatility in the broader market is a crucial driver of slippage, as rapid changes can happen within a single block confirmation time.
3. Large Trade Size: Larger trades consume more liquidity from the pool, moving the price further along the curve. This increased price impact results in more slippage, especially if the trade size is substantial relative to the liquidity available in the pool.
4. Longer Block Confirmation Times: The time it takes for a transaction to be executed and confirmed on-chain can introduce slippage. During this delay, prices can move due to other transactions being processed, particularly on networks with slower block times or during periods of high congestion.
5. AMM Design: The structure of the AMM itself can contribute to slippage. Newer designs, such as Uniswap V3, optimize liquidity by allowing providers to concentrate their assets within specific price ranges. This concentrated liquidity approach helps reduce slippage within those ranges, but outside of them, slippage can still occur.
6. Protocol Execution Speed: The speed at which the AMM processes transactions also influences slippage. Faster execution times reduce the window for price fluctuations, while slower protocols increase the risk of slippage.

Slippage is inherent in decentralized markets using AMMs and traditional financial markets. While it cannot be eliminated entirely, traders can take steps to mitigate its effects, which will be discussed in the following sections.

Types of Slippages

Slippage can occur in two forms: positive slippage and negative slippage. Both are driven by the same market dynamics, but their outcomes differ depending on how prices move between when a trade is initiated and when it is executed.

Positive Slippage

Positive slippage occurs when a trade executes at a price better than expected, meaning the trader gets more value than initially anticipated. For example, if a trader expects to buy a token at $100 but the price drops to $95 during execution, the trade benefits from a lower purchase price. Positive slippage results in receiving more tokens for the same amount or spending less of the trading asset than expected.

On-chain and market conditions that lead to positive slippage:

• Low trading volume: When the market or liquidity pool is not heavily congested with transactions, prices may adjust slightly in the trader's favor before the trade executes.
• Increased liquidity: If additional liquidity enters the pool after the trade is initiated but before execution, the price might improve, resulting in positive slippage.
• Market stabilization: When price volatility decreases or stabilizes unexpectedly, trades may execute at a more favorable rate than when they were initially placed.

Negative Slippage

Negative slippage, on the other hand, happens when a trade executes at a worse price than expected. This is more common and undesirable for traders, who receive fewer tokens or pay more than anticipated. For example, if a trader expects to sell a token at $100 but the price drops to $95 before execution, the trade is executed at a loss relative to the expected price.

On-chain and market conditions that lead to negative slippage:

• High trading volume: In periods of intense market activity or high trading volume, liquidity may become constrained, causing prices to shift against the trader before the transaction is finalized.
• Low liquidity pools: In pools with insufficient liquidity, even small trades can move the price curve significantly, making it more likely for traders to experience negative slippage as their trades impact the asset price.
• Market volatility: During periods of extreme volatility, prices can change rapidly, leading to slippage in either direction, but negative slippage is more likely when prices move unfavorably before a trade executes.
• Block confirmation delays: Longer transaction confirmation times on the blockchain increase the time window during which prices can fluctuate, leading to a higher likelihood of negative slippage.

While positive slippage can benefit traders, negative slippage is more common and presents a risk in volatile or low-liquidity markets. Both types are natural outcomes of the way AMMs and liquidity pools function.

How to Minimize Slippage

While it's impossible to completely eliminate slippage, as it is a fundamental aspect of liquidity pools and financial markets, there are several strategies traders can use to minimize its effects. Understanding these measures can help improve trading efficiency and reduce the risks associated with price fluctuations.

1. Using Limit Orders: Limiting orders is an effective way to manage slippage. Unlike market orders, which execute trades at the best available price, limit orders allow traders to set a maximum or minimum price at which they are willing to trade. If the price moves beyond this threshold, the trade is reverted, ensuring it only executes at or better than the set price. While this method doesn't guarantee instant execution, it can prevent unfavorable price slippage.
2. Setting Slippage Tolerance Levels: Many decentralized exchanges (DEXs) allow traders to set a slippage tolerance level. This defines how much a price deviation is acceptable before a trade reverts. For example, a trader might set a slippage tolerance of 1%, meaning the trade will execute if the price does not exceed this threshold. However, it's essential to strike a balance, as too low tolerance can cause frequent reverts, while a high tolerance may expose the trader to unnecessary slippage losses.
3. Avoiding Small Liquidity Pools: Trading in small liquidity pools increases the risk of slippage because fewer assets are available to absorb the trade without moving the price significantly. By choosing pools with sufficient liquidity, traders can reduce the likelihood of price fluctuations during execution. Larger pools can better accommodate trades without drastically altering the price curve.
4. Choosing Exchanges with Better Slippage Management: Different exchanges handle liquidity and slippage differently. Platforms like UniswapX improve the slippage experience by sourcing liquidity from multiple pools and exchanges. This aggregation allows traders to access deeper liquidity and reduce the price impact of their trades. Selecting exchanges that implement advanced liquidity management can help minimize slippage.
5. Avoiding Large Orders: Larger trades tend to significantly impact the price curve, especially in pools with limited liquidity. Breaking up large orders into smaller trades can reduce the impact of slippage. This strategy is especially effective when trading in less liquid markets or during periods of low activity.
6. Being Cautious During Market Volatility: Market volatility can exacerbate slippage as prices move rapidly during these times. To avoid unexpected price changes, traders should be cautious when trading during high volatility. Monitoring market conditions and placing trades during more stable moments can help mitigate the effects of slippage.
7. Selecting Optimal Trade Times: Another way to mitigate slippage is by choosing optimal times to trade. Avoiding periods of network congestion (such as during major market events) can reduce delays in transaction confirmations, reducing the likelihood of slippage. Networks with high gas fees during peak usage times may also introduce delays that can contribute to slippage.
8. Using Aggregators: DEX aggregators such as 1inch or Matcha combine liquidity from various sources to ensure better execution prices. These platforms scan across multiple liquidity pools and choose the most efficient trade routes, reducing slippage by ensuring that trades are executed in the pools with the least price impact.

Slippage is an unavoidable part of trading, especially in decentralized markets. However, traders can significantly reduce its effects by employing strategies like limit orders, setting appropriate slippage tolerance levels, and choosing the right exchanges. Although slippage cannot be completely eliminated, understanding these measures helps traders optimize their trades and mitigate unnecessary losses.

What is Slippage: Closing Thoughts

Slippage is not something traders should shy away from but rather a phenomenon to embrace as part of trading in decentralized markets. It reflects the dynamic nature of liquidity pools and AMMs, which continuously adjust prices based on supply and demand. Instead of trying to avoid slippage altogether, traders should understand it and learn how to manage it effectively.

Under normal conditions, traders can typically tolerate up to 0.5-1% slippage without experiencing significant losses. However, if slippage exceeds this threshold, it may be worth reconsidering the trade by choosing a better market time or finding a more liquid pool to execute the transaction.

Fortunately, modern AMMs have become highly efficient in managing liquidity and slippage, thanks to technological advances and liquidity optimization. The overall liquidity within Web3 markets is increasing, driven by the growing number of users, liquidity providers, and sophisticated DEX designs. As a result, slippage for highly liquid trading pairs, such as Ether and stablecoins, has become almost negligible, offering smoother and more predictable trading experiences.

By leveraging these insights and strategies, traders can optimize their trades and better navigate the world of decentralized finance, mitigating the impact of slippage where possible.