blog.alankrit.net

Tag: slippage

  • Day 20 — Why Would Anyone Put Their Tokens Into a Liquidity Pool?

    Watercolor illustration of liquidity providers adding a pair of tokens to a shared trading pool

    An automated market maker cannot serve traders with an empty pool. The assets are supplied by liquidity providers, often called LPs. They deposit a pair of tokens into a smart contract so other people can swap between them.

    Suppose a pool holds ether and a stablecoin. A provider contributes both assets at the pool’s current value ratio and receives a token or accounting record representing a percentage of the pool. If the provider owns one percent of the pool, that claim grows or shrinks with the pool’s reserves.

    Every swap usually pays a small fee. The fee remains in the pool or is distributed according to the protocol’s design, giving LPs a reason to provide capital. More liquidity also benefits traders by reducing slippage, so a healthy market tries to balance useful depth with a fair return for providers.

    The catch is that the pool constantly rebalances the two assets as prices move. If ether rises sharply, arbitrage traders remove ether from the pool and add stablecoins until the pool matches the outside price. The LP ends up holding less of the asset that rose and more of the asset that lagged.

    Compared with simply holding both tokens, this difference is called impermanent loss. The name can be misleading: if the provider withdraws while prices are far apart, the loss relative to holding becomes real. Trading fees may offset it, but they are not guaranteed to do so.

    LPs also face smart-contract bugs, malicious tokens, oracle or bridge failures in some designs, and the possibility that an incentive token loses value. A high advertised annual return says little unless we know the trading volume, fee income, price risk, and source of extra rewards.

    Liquidity provision turns passive assets into market infrastructure, with rewards tied to real risks. Another kind of pool uses deposits not for swaps but for loans. Tomorrow we will see how lending can work without a bank checking your credit score.

  • Day 19 — How Can You Trade Without an Order Book?

    Watercolor illustration of an automated market maker balancing two token reserves in a liquidity pool

    A traditional exchange keeps an order book: buyers state the price they will pay, sellers state the price they will accept, and the exchange matches them. Many decentralised exchanges use a different machine called an automated market maker, or AMM.

    An AMM stores two assets in a smart contract called a liquidity pool. Imagine a pool containing ether and a stablecoin. A trader who wants ether adds stablecoins to the pool and removes some ether. The contract calculates the amount using a mathematical rule instead of waiting for a specific seller.

    A common simplified rule is x multiplied by y equals k. Here x and y are the quantities of the two assets, while k should remain roughly constant after a trade, before fees. When ether becomes scarcer in the pool, the formula makes each additional unit more expensive. The pool’s ratio therefore moves as people trade.

    The displayed price is not an opinion formed by the contract. It emerges from the current reserves. If the AMM price differs from larger markets, arbitrage traders buy from the cheaper place and sell to the expensive one. Their transactions push the pool back toward the wider market price.

    Large trades move the reserve ratio more than small trades. The difference between the expected price and the executed price is called slippage. Deep pools usually produce lower slippage, while a thin pool can move dramatically from a modest transaction. Slippage limits protect users from accepting a much worse result than expected.

    AMMs make always-available on-chain trading possible, but their contracts, tokens, and pools still carry risk. A fake token can use a familiar symbol, a pool can be too shallow to exit safely, and a poorly chosen slippage setting can invite manipulation or failed transactions.

    The pool clearly needs assets before anyone can trade. Tomorrow we will meet the liquidity providers who deposit those assets, collect fees, and take on a less obvious risk called impermanent loss.