What is Price Impact ? Effect of Price on Transactions in DEXs

 

To use new financial systems in the crypto market, including decentralized exchanges (DEX), we need to be aware of what might happen to our assets while trading on these platforms. If you are also interested in using decentralized exchanges, you must have encountered the phrase Price Impact. In fact, Price Impact is the difference between the current market price and the price paid during a swap in a decentralized exchange. This happens in docks due to the imbalance of liquidity in their pools and the sudden change in prices in a token. In this article from coinmarketsig.com, we will look at what Price Impact is and how to prevent it from happening. Stay with us.

 

What is Price Impact ?

Defi (decentralized finance) can be an incredibly exciting experience for those who have never had access to financial markets. However, people who work in this field without sufficient knowledge may face problems that put their assets at risk. Price Impact generally occurs in ducks and is due to the way the ducks work, which is tied to Automated Market Makers or AMMs. AMMs work by using mathematical formulas to determine the price of a token, and trading in them with smart contracts. There are no buy and sell orders in the docks and the smart contract acts as the buyer in the transaction. Equivalent (one-to-one) ratios are commonly used in the liquidity pools of decentralized exchanges. This causes the balance in DEX pools to be upset by buying or selling a token, and DEX uses Price Impact to maintain this balance. The following is an example.

Suppose we choose a token from among different tokens and intend to buy and invest in it for $100. The price of each token is $0.01, we buy this token at this price, and after making the purchase, we have 10,000 of these tokens. Then the price of this token suddenly goes up and the price of each unit reaches $0.1, now our $100 investment has become a $1,000 capital and we intend to cash it. We transfer it to one of the decentralized exchanges and turn it into ether; but after receiving our quin ether, we find that we received $ 200 ether instead of $1,000. We wonder here what happened to our remaining $800. Did we see the token price wrong? Or maybe the network fee was too high? None of this has happened, and it was actually the sale of the same 10,000 tokens that caused us to have a price impact.

This happens when the liquidity in the pool where we swap is low. This may seem like a scam, yet it also happens in traditional financial markets. In these markets, too, if you make a large volume transaction, as long as the moneychanger has stock, he will make the transaction at the same price as you request; but then everything that remains of your deal is done at the lowest price.

This concept is exactly the concept of supply and demand. If there are only 100,000 of these tokens in the pool where we have sold our 10,000 tokens, in a moment supply will outstrip demand or demand will outstrip supply, causing the price of this asset to fall or rise. In general, this is due to the fact that this token is not widely traded by individuals in various DEXs.

It is worth noting that this does happen in the case of not only selling tokens, and you may also encounter this to buy a token. For instance, if you want to buy 20% of a token in a pool, DEX automatically raises its price, and you pay more than the actual price of that token to buy it. Price Impact can also be said to be a mechanism to prevent whale behavior from upsetting the balance in the DEX pool. The whales ‘capital is very high, and when they turn to the docks to convert their assets, they upset the balance in the DEX’s pool. To prevent imbalances in their pools, DEXs raise the price of the token that the whales intend to convert so high that it is unprofitable for them to make the deal and refuse to do so.

 

How does Price Impact work?

Price Impact occurs due to the pricing model in decentralized exchanges. By changing the ratio of pool assets in a deck, the supply of one token increases and the supply of another token decreases. This will increase the price of the token whose inventory has been reduced. The more the asset balance ratio changes in the DEXterity liquidity pools, the more the price fluctuations are affected, and these changes will be much greater in pools with less liquidity than in pools with large amounts of liquidity.

Suppose a pool of liquidity has 1,000 quinces of ether and $2,000,000 of token tokens, and the price per unit of ether is $ 2,000. In this pool, the balance ratio between coin ether and tetra is 50 to 50.

Exchanging 10,000 units of ether with ether in this pool causes the balance of this pool to be disturbed by 0.48%, which is called the price impact, and the purchase price of ether for the person who performs this swap is equal. Can be made with ether price * 0.48% which is equal to 2009.64 dollars; This means that the user has to pay $9.64 more than the market price of ether to buy each unit of ether.

Now, if we want to buy $100,000 from this ether pool, Price Impact will be calculated at 4.99% and the price per unit of ether is $2099951 for us. The reason we cannot trade our ETH at the market rate in ducks is that if, for example, we swap $2,000,000 USDT with ETH in this pool, the entire ether of this pool is empty and only 4,000,000 the tetra dollar remains.

 

How do we make sure we do not get Price Impact?

First of all, we must keep in mind that high impact prices often occur when trading new and unstable tokens in the market. If you are interested in buying and selling a token with these specifications, you should consider the following points:

 

Value

If you think you are moving a large volume of a token, first search for the token’s counter address in blockchain browsers such as EtherScan, depending on the token’s network type, and see the volume that other people are moving. If the volume you are moving is less than the average volume of other people moving, you should not worry about this. However, if your average volume per move is higher than the rest, you may have a high Price Impact.

The image above shows the FEG token trading volume chart. You can find out the volume of transactions by referring to the various blockchain search engines and searching for the smart token contract you are considering.

 

Pool depth

Finding the depth of new pools is not easy; newly created tokens often do not have a high volume of transactions and their transaction information is not recorded properly. These tokens are often not listed in large exchanges and are limited to a specific decentralized platform and application (DAPP). That is why people have to use these platforms to buy them. To purchase a token, it is recommended to find a pool on a large, well-known and reputable platform that has a lot of cash in their pools and supply and demand are almost balanced.

In the image above, which is in the Pancakeswap exchange office, by going to the Info section and going to the Liquidity section of your token, you can find out the depth of that pool, which is marked with a red box in this image.

Use of aggregators

Try to use DEX Aggregator to do your trading; DEX aggregators are platforms that automatically search for various decentralized exchanges and select the DEX that offers the best price for the transaction. It is also recommended to use aggregators such as MetaMask Swap, which takes into account the effects of Price Impact and automatically alerts you. One of the best DEX Aggregators is the 1inch protocol, for which you can read the following article.

 

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In conclusion

Even if you have been in the crypto market for a long time, you should know that as it expands, new concepts are added to it every day, and you may incur financial losses by not being aware of these new things. Defi is as complex as traditional financial markets, and perhaps more so because of its novelty in financial concepts. Price Impact is one of the risks to users of ducks, which may lead to the loss of part of their assets. Doing business in Defi can be a risky business. Even if you know what you are doing. In this article, we discuss what Price Impact is and how to prevent it from happening. If you have experience working with ducks and encountering Price Impact, share your experiences with us.