The phenomenon known as price impact is a constant pain for traders who are familiar with high-frequency trading or have ever traded on cryptocurrency exchanges. When the effects of a price impact take place, traders are at a loss, bringing about frustration and financial setback.
What Is Price Impact?
The phenomenon of price impact can be best explained by the sudden change in the price of an asset as a result of the processing and execution of the transaction related to it.
The price impact itself is calculated in the form of the size of the order being traded in relation to the amount of liquidity currently available. The relationship that follows includes the fact that a reduction of the supply in tokens brings about an increase in the prices of tokens still available in circulation as a result of the inverse relationship between supply and demand. This follows that an increase in the demand for tokens as part of a trade will result in the average increase in the price of each remaining token. Since the available supply will have to be filled up through various sources and will take time, the price impact of a trade will likely remain and result in losses for traders affected by it.
Price Impact and Slippage
In many cases, price impact is compared to slippage. However, the two concepts are quite distinct in their natures and their only coinciding factor is the loss to traders that they result in.
While price impact is the result of a direct action on the part of traders, slippage is a phenomenon that is not enacted by traders and takes place as a result of external factors. Price impact is directly proportional to the size of a trade order, while slippage results from blockchain block mining time lags and the difference in market pricing between the time a transaction is put up for hashing and the time it is actually processed.
Price Impact on DEXs
Decentralized exchanges are known to be most affected by slippage by virtue of their complete reliance on the blockchain as a basis, with no centralized authority controlling the order book. However, apart from slippage, the effects of price impact are also more pronounced on decentralized exchanges, since the pricing mechanisms in effect are different. There are several types of price impact that need to be explored in order to fully divulge the essence of the phenomenon.
The AMM Price Impact
An AMM mechanism, or Automated Market Maker, relies on a pool, which contains a certain number of tokens needed for the trades to take place. There is also a price curve in place, which relies on the supply of available tokens. However, the mechanism of a pool also relies on a complete balance, which means that the addition of one token will result in the subtraction of another in their direct proportionality.
For instance, if a trade involves the purchase of 1 ETH for 177,000 TON, this means that the users party to the trade will be subtracting from the pool 1 ETH and adding 177,000 TON in return. The inverse relationship between supply and demand thus takes effect, resulting in the rise in price of the suddenly scarcer ETH and the drop in price of the abundant TON token.
The scale built into the AMM price curve thus guarantees that the tokens available are fairly scaled in price to their available quantities in the pool. Though the mechanism seems fair, it results in a high price impact ratio in pools, which have a limited quantity of tokens available, forcing traders to mitigate the risks involved. Traders are advised to fractionalize their trades into smaller chunks to avoid higher price impact effects.
The Order Book Price Impact
The peculiarity of DEX order books is that active limit orders can be executed only once a matching order is located and this means that price impact effects are negated. If traders wish to avoid the effects of price impact on a DEX, they can always set their trade limit order within the boundaries of a bid-ask spread. This means that the order will be executed once the limit order threshold is reached on a market price level. In essence, the trader is simply setting a price floor or ceiling, meaning there is no price impact to be had.
However, if a trader decides to set a limit order, which is substantially above or far below the prices on the market, then the price impact phenomenon will come into full swing. The onset of price impact could be sudden and accidental as a result of erroneous parameter input, or due to the execution of a sophisticated, but flawed, strategy that involves significant amounts of tokens with predetermined prices as part of the algorithm. The effect of price impact in this case will include the difference in price of the price set in the limit order and the market price.
Mitigating Price Impact
Traders have several tools at their disposal, which can help them mitigate the risks posed by price impact. The first is, of course, the ability to split their trades into smaller portions and avoid placing large orders. This approach comes hand in hand with the diversification of liquidity sources and the distribution of trades between different platforms, thus allowing profits from one to cover losses from another.
There is also the ability to manually mitigate risks in the case of a swap by reducing the size of the order. If that is not an option, the only choice left will be to either look for a platform that has more liquidity, or simply wait for an additional injection of funds to the selected platform. Naturally, if the liquidity is not being injected, the user should think whether the platform of choice is reputable enough to be trusted.
Key Takeaways
Price impact is a phenomenon that takes place when the market price of an asset changes during the conduct of a transaction as a result of the difference in the price of the underlying asset following a shift in the available supply and demand. Traders are advised to keep the effects of price impact in mind when dealing on DEXs, since many platforms of this type do not have sufficient liquidity and are decentralized by nature, meaning they also can incur slippage effects.
