Understanding Slippage: Causes and Factors Influencing Slippages During Volatile Markets

Slippage is a phenomenon that occurs when there is a discrepancy between the expected price of an asset and the actual execution price of a trade. Slippage can result from a variety of factors, including market volatility, trading volume, and liquidity. Slippage can be a significant concern for traders and investors, as it can lead to unexpected losses or missed opportunities.

In this study, we will focus on three specific cases to better understand slippage in different contexts. The first case is a comparison of volume-wise slippage graphs in lower and higher liquidity markets. The second case is a comparison of price impacts of mid-cap vs large-cap pools. The third case is a comparison of slippages in a volatile market (FTX crash) vs a normal market.

What is Slippage?

Slippage refers to the difference between the expected and actual execution price of a trade. It is a common phenomenon in DEXs, where there is no central authority to manage trades and the order book. Unlike centralized exchanges, DEXs use smart contracts to execute trades, which can lead to higher slippage due to the lack of liquidity.

There are two main types of slippage in DEXs: price slippage and liquidity slippage.

• Price slippage occurs when the market price of an asset moves while a trade is being executed. For instance, if a trader submits a market buy order for an asset, the price of the asset may increase before the order is executed, resulting in a higher execution price and price slippage. Similarly, if a trader submits a market sell order for an asset, the price of the asset may decrease before the order is executed, resulting in a lower execution price and price slippage.
• Liquidity slippage occurs when there is not enough liquidity in the market to fulfill the full size of an order. For instance, if a trader submits a large market buy order for an asset, and there is not enough liquidity in the market to fulfill the order, the order may be partially filled at different prices, resulting in liquidity slippage. Liquidity slippage can be exacerbated in DEXs due to the lack of liquidity, which can result in wider bid-ask spreads and higher trading fees.

What Causes Slippage?

Slippage can be caused by a variety of factors, including market volatility, low liquidity, and order size. Let’s take a closer look at each of these factors and how they can contribute to slippage.

1. Market Volatility:

Market volatility can cause slippage in DEX trades because the price of assets can change rapidly in response to market demand and supply. When there is high volatility, there may be sudden price movements that result in a significant difference between the expected price and the actual price at which a trade is executed.

For example, if there is sudden demand for a particular token on a DEX, the available liquidity may not be sufficient to meet the demand, and the price of the token may increase rapidly. If a trader places a market order to buy the token at the current market price, the order may be filled at a higher price than expected, resulting in slippage.

Likewise, if there is sudden selling pressure on a token, the price may drop rapidly, and a trader may end up selling their token at a lower price than expected, resulting in slippage.

2. Low Liquidity:

Liquidity refers to the amount of available funds or assets that are available in a particular market or trading pool. In DEXs, liquidity is provided by liquidity providers who deposit tokens or assets into the pool. If there is a low level of liquidity in the pool, it can be more difficult to execute trades at favorable prices, leading to slippage.

3. Order Size:

The order size can significantly affect slippage in DEX trades. Large orders, or orders that exceed the available liquidity on a DEX, can result in significant slippage because the price of an asset may change as the order is filled.

When a trader places a large order on a DEX, the order may exceed the available liquidity at the desired price, which can cause the price to move as the order is filled. As a result, the trader may end up paying a higher price than expected, resulting in slippage. This is especially true for market orders, where the trader accepts the best available price at the time the order is executed, regardless of the price difference.

Additionally, slippage can also occur due to network congestion or technical issues with the DEX platform.

Methodology

The research design for this study involved monitoring swaps for a period of 30 days within the timeframe of 8:00 PM to 8:30 PM in the USDC/ETH pool on a decentralized exchange. This timeframe was selected as it is a high-volume period for decentralized exchanges and thus more representative of market conditions. The swaps were monitored to determine the slippage, which refers to the difference between the expected price of a trade and the actual price at which the trade is executed.

To collect and analyze data on swaps, a data analysis tool was used, specifically designed for decentralized exchanges. After collecting and analyzing the data, we used seaborn and pandas to create graphs that allowed us to observe any trends or patterns in the slippage, providing valuable insights into the potential impact of slippage on traders and investors.

Comparison of Volume-Wise Slippage Graph in Lower and Higher Liquidity:

The USDC/ETH 0.05% pool on Uniswap V3 allows users to swap USDC (a stablecoin pegged to the US dollar) for ETH (the native cryptocurrency of the Ethereum blockchain) and vice versa. The pool charges a fee of 0.05% on each trade made in the pool.

The above graph compares the slippage experienced by users trading in the USDC/ETH pool at two different levels of liquidity: higher liquidity (34–34 million) and lower liquidity (20–21 million). Liquidity refers to the total amount of cryptocurrencies available in the pool for trading. The USDC/ETH pool has the highest Total Value Locked (TVL) among all USDC/ETH pools on Uniswap V3, and it is also the most active pool.

The graph shows that when the liquidity in the pool is higher (i.e., more cryptocurrencies are available for trading), the slippage experienced by users tends to be lower. Conversely, when the liquidity is lower, the slippage tends to be higher, indicating that users may experience a greater difference between the expected price of a trade and the actual price at which the trade is executed.

To ensure a fair comparison, the data for the lowest 3 negative slippages and highest 3 positive slippages were removed.

Comparison of Slippages in Volatile Market ( FTX Crash) vs Normal Market:

The slippages experienced by users trading in the USDC/ETH pool on Uniswap V3 during two different market conditions: a volatile market and a normal market.

The volatile market time period considered in the graph is from Oct-25–2022 to Nov-23–2022, during which the cryptocurrency market experienced a significant crash. The normal market time period considered in the graph is from Jan-21–2023 to Feb-19–2023, which is a period of relative stability in the cryptocurrency market.

The graph is divided into two sections based on the volume of the trades: below 5 lakh value and 5 lakh to 2.25 million volume(USDC).

In the above graph of below 5 lakh value, the graph shows that during the volatile market period, the slippages experienced by users were generally higher than in the normal market period. This indicates that users were more likely to experience a difference between the expected price of a trade and the actual price at which the trade was executed during the volatile market period.

In this graph i.e. 5 lakh to 2.25 million volume, the graph shows a similar trend where slippages are higher during the volatile market period compared to the normal market period.

Comparison of Price Impacts of MidCap vs LargeCap pools:

In the graph, we can compare a MidCap pool and a LargeCap pool on Uniswap V3. The MidCap pool is the AAVE/ETH pool with a 0.3% fee and a TVL of 3.93 million, while the LargeCap pool is the USDC/ETH pool with a 0.05% fee and a TVL of 214.62 million.

The graph shows the negative price impacts of trades made in these two pools. Negative price impact refers to the difference between the expected price of a trade and the actual price at which the trade was executed. This cost is incurred by the trader due to the market impact of their trade.

The LargeCap pool, with a much higher TVL, generally experiences lower price impacts compared to the MidCap pool. This indicates that the LargeCap pool is more liquid and can better absorb large trades without significantly affecting the price of the assets being traded. On the other hand, the MidCap pool with lower liquidity can experience higher price impacts, especially with larger trades.

The graph only shows negative price impacts because positive price impacts are almost always zero, due to the single swaps. This means that when a trader is buying an asset in the pool, the price impact is almost always zero. However, when a trader is selling an asset, they will experience a negative price impact.

In conclusion, Slippage can have a significant impact on traders and investors in high-volatility markets. Understanding the causes and factors that influence slippage is essential to minimize losses and maximize profits. Market volatility, low liquidity, and order size are some of the critical factors that can contribute to slippage. Additionally, technical issues with the DEX platform can also cause slippage to occur.