Crypto 101: Understanding Slippage
While slippage may seem like a confusing topic, it’s actually quite simple once you understand what is happening ‘under the hood’.
Slippage is not unique to crypto assets. Those who invest in legacy finance are also confronted with the same issue. The simple explanation for slippage is the difference in price between the order you place and the order you receive. The reasons why the prices change is a little more complex.
To understand why slippage occurs, it helps to understand how trading and liquidity work. While those are both broad topics, a brief overview should work for our purposes. In order to trade anything, there must be something to trade it for.
The way exchanges handle this is by creating pools of assets. For assets that go up and down in price, like stocks or crypto, the easiest way to trade those assets is to pair them with a stable asset like Euros.
The goal is to keep all the paired pools in a 50:50 balance. If the market for the pooled assets is stable, then the trades will usually balance out. Some people will want to trade the asset for Euros, while others will trade Euros for the asset.
But in times of high volume or volatility, those pools can become unbalanced. The way the exchange rebalances them is to adjust the price of the asset up or down. This way the pools will remain in a 50:50 ratio.
This is also why the price of an asset goes up and down on the market. If more people want to trade the asset for Euros than the other way around, there will be more assets than Euros. Because of this, it will require fewer Euros to buy the asset (asset price goes down).
The larger the pool, the more liquid it is. This means there are more of each asset available to trade with. If an asset has low liquidity, large purchases can easily upset the balance and cause the price to rise rapidly. But if an asset has high liquidity, large purchases have less of a price impact.
This is where slippage comes in. If you are buying a very low liquidity asset, like a brand-new crypto token, even relatively small purchases can cause the price to go up. Most Decentralized Exchanges (DEX) will show you what impact your purchase will have on the price, usually expressed as a percentage.
Here’s an example from PancakeSwap:
As you can see, if this trade were executed, the price would change by 0.02%. The reason the price impact is so low is because the trade is relatively small and PING has a very large liquidity pool.
But as the trade gets larger, or the liquidity gets lower (or both), the price impact will rise. If the trade is very large, or the liquidity gets very low, the price impact might exceed the slippage tolerance. If that happens, the trade will fail (out of tolerance).
In effect, slippage tolerance mimics the stop and limit functions on centralized exchanges that use an order book model. Stop and limit functions are conditions that must be met for a trade to occur (execute). In an order book model, a trader will receive a quote price and the trade will execute when the price reaches a level either above or below that price (confusingly called a ‘stop’).
But if the price rises too high or goes too low, the limit condition will prevent any further trades beyond the limit price. In a sense, slippage tolerance automates this function by providing a range that a price can fluctuate and still allow an order to successfully execute.
Often new projects will charge a tax to buy or sell their token. This serves a couple of useful functions for the project. The most obvious one being the tax will bring revenue back to the project to fund things like development.
It also helps prevent excessive speculation or swing trading of the token. Because new projects often have low liquidity, people with lots of money can manipulate prices and make money by carefully timing trades. The most common tax rate set by new projects is around 10% on each transaction.
This discourages price manipulation trading, because it becomes much harder to time trades and make money on price fluctuations. With a 10% tax in place, a trader would have to buy enough to move the price by at least 10% before there would be an opportunity to profit. But this puts them at risk for someone else to take profit at their expense.
In order to overcome the tax, the slippage must be set to a rate that is high enough to pay the tax and to cover the price impact. In other words, if a token has a 10% tax, the slippage would have to be set at 10.5% or higher to ensure the trade executes (tax + price impact).
Since a DEX is automated, all of these functions occur without user intervention. And as noted before, if a token has very low liquidity, prices can fluctuate wildly. One solution is to raise the slippage tolerance to ensure the trade executes.
However, when you raise the slippage tolerance to a high rate, like 10–12%, you may get a warning that the trade will be vulnerable to front running. Front running is a practice where automated programs (bots) take advantage of high slippage tolerance trades.
Because all transactions on a DEX are automated, orders are queued according to the time the order is placed and how much gas (fee) is being offered to trade. However, a clever programmer can ‘see’ which trades are in the execution queue.
If you place a large enough trade in the queue, the front runner can raise the gas fee they are offering to move up in the execution queue (get in front of the large order). The bot will then buy the asset at the quote price, which drives the price up (price impact).
The bot will then execute a sell to the next order in line (yours), which means you end up paying a higher price than you were expecting. The way to combat this is to keep the slippage low, which will prevent your order from executing if someone tries to manipulate the price this way.
This is only a major problem if you are placing a very large order. It is difficult to make money front running small trades. If you are going to place a large order, a good practice is to break them up into smaller ones. This will reduce the likelihood of you getting front run.
If you are buying a new token with a standard tax rate of around 10%, you will most likely see a warning from the DEX that you might get front run (because of the high slippage tolerance). However, another nice function of the tax is it also makes it much harder to front run transactions.
If your orders are less than a few thousand dollars, you probably won’t have to worry too much about the warning. But even with a tax in place, a large enough order may still provide a tempting target to the bots. If you’re placing an exceptionally large order, you will have to balance between the risk of getting front run against paying the tax multiple times if you break the order up into smaller ones.
Hopefully this article has helped clear up what slippage is and how it works. For the vast majority of crypto investors buying ‘blue chip’ tokens like BTC or ETH, slippage will rarely be an issue. But often the projects with the highest potential to go up in value are traded on DEXs. Now that you know this information, you should be able to more confidently participate in those projects.
Just remember, all crypto projects you invest in are experimental. This includes the DEXs you trade on. When using a DEX, always be sure to verify the website address and be sure you are interacting with your intended token contract. Take your time and only trade small amounts until you are comfortable using the platform. If you do that, you’ll be safely using DEXs in no time.
I hope you’ve found this helpful. Of course, these are just my opinions. I’m not a financial advisor, this isn’t financial advice, and always DYOR. Following any of these ideas might cause you to lose all of your money. I am 100% serious about that. I like tinkering with this stuff, but I’m on record acting like a total baboon. Invest accordingly.
Until next time, be safe, be smart and be sure to tie the camel.