The Slippage Conundrum
Is zero-slippage really the dream?
Welcome Degens, markets are experiencing turbulent times, and instead of covering the same matter as most people are doing concerning FTX, we will dive into a matter that normally confuses a lot of traders to take your mind off the situation for a bit.
Anybody who has partaken in prime shitcoinery knows how frustrating slippage can be when you interact with decentralized exchanges. Trying to buy tokens with low liquidity and increasingly having to increase your slippage as you get front-run is something a lot of degens have dealt with. Nothing is worse than the slowly creeping despair as you increase your slippage while trying to sell a token and the transaction is loading. You take a deep gulp and watch the screen frantically as you see the transaction bar turn red. You have most likely been rugged as the devs pulled liquidity. Money down the drain again. This has led to a negative experience among many traders, which is why we’re now seeing a trend of protocols emphasizing that they are a zero-slippage exchange.
However, is that always a good thing? Before we dive into that, we have to explain what slippage is.
What is slippage?
When you enter an exchange and want to trade an asset, it will display a spot price that it’s currently trading for. If that price appeals to you as a trader, you would decide to execute a buy/sell order (or swap in the case of DEXs). As you are executing the trade, you realize that the price has changed and the deal you were initially getting is no longer there. That is what slippage is and in times of low liquidity associated with new launches, it can get frustrating as the price constantly changes while you’re trying to enter a position. Moreover, there is no doubt that there has been frontrunning taking place as predatory environments allow market makers to give their clients worse orders (ahem Citadel).
However, on the topic of slippage, people tend to forget that it works both ways and can sometimes turn in your favor. However, due to human cognitive bias, we tend to only associate it with the bad experiences we have instead of taking into account when it has benefitted us. Why? Because it happens most frequently in these scenarios:
You’re trying to FOMO buy a token and constantly get updated pricing which means that you have to pay more for the token
You’re trying to panic sell a token during times of black swan events or high market volatility as the token price tanks.
Nonetheless, slippage is not exclusive to decentralized exchanges despite it being more prevalent there at times. The less liquidity that is available for your token, the more slippage you will experience as the price impact of every executed trade bears higher.
If you hate slippage you should use limit orders instead of market orders as they will be filled at your desired price or not at all.
Is it that bad?
The obsession with slippage being bad is a conundrum that has been discussed with other big brains in [Redacted]. The thought of wanting to solve something that has always existed is strange. Even if you just extrapolate it doesn’t make sense that prices would stay the same if the balance of the liquidity pool changed. If you buy x amount of tokens, why would the price remain as it is? It’s natural that some kind of change would occur. Now, we have seen exchanges dealing with this through the use of oracles such as Chainlink. While this mitigates the problem they are not perfect as the inherent flaw of Chainlink oracles is that they not do not factor in price impact on large orders.
This means that zero-slippage exchanges that solely rely on oracles for their pools can have a substantial amount of their pool filled during times of high volatility leaving a lot of capital at risk.
There is a reason why traders with high volume usually operate on centralized exchanges instead of decentralized exchanges as there typically isn’t enough liquidity for them without a heavy price impact. This becomes a problem in itself as well as tons of people get frustrated by trading on FTX considering the pricing they receive due to slippage.
However, if traders would deploy a substantial amount of capital in zero-slippage exchanges they could cause immense damage in a short amount of time. We have already seen instances of this in the leading perp exchange on Arbitrum.
In this case, a trader manipulated the market by taking advantage of the zero slippage feature as large orders were being filled as price impact wasn’t factored in (it was not an exploit as the protocol was working as intended due to its design)
When smart traders get offered large trades at zero slippage they lick their lips (especially in times of volatility) as they can fill their positions instantly to detriment of the other counterparty. This works great when you’re generally dealing with retail traders that have non-significant sizes but when savvy traders turn up it might become an issue. It’s completely opposite to a standard market maker that would widen their spreads in times of high volatility as uncertainty looms over the market.
Note: I’m not knocking GMX as a protocol. However, it provides a perfect case study on this topic. The protocol mitigated the issue with a new oracle system that prevents frontrunning.
Another example of flawed zero slippage models is the “profitable trading strategy” on Mango Markets, as we’re apparently calling it now. Manipulating the oracle price by acquiring a significant amount of MNGO tokens on separate exchanges from one wallet while opening a perp position from another wallet. As the token is fairly illiquid it was pumped and then a loan was taken against the “pumped value” that was still in an open position (the less said about the design the better). Then taking out a $116 million loan against the open position and let the loan get liquidated. Checkmate.
Instead of being bamboozled by exchanges marketing zero slippage, I suggest that you take an interest in the projects that are trying to solve a more relevant matter such as impermanent loss that directly affects LPs' profitability.
Key Takeaways
An increasing number of protocols use zero-slippage in their marketing efforts without seeming to understand the inherent flaws that the model entails. While it is effective to attract retail traders, I don’t expect it to end soon but more transparency would be welcome concerning zero slippage which a lot of traders are not aware of since they are being offered good pricing (to be fair the pricing is very good). Even so, everything comes at a risk, and trying to reinvent the wheel is not necessarily the solution that the market needs. As long as traders can operate in a low-slippage environment with attractive trading fees I struggle to see anyone complain. However, that might just be me.
What is your opinion of slippage in decentralized exchanges? Let me know in the comments below.
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Disclaimer: All Content on this site is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing on the site constitutes professional and/or financial advice, nor does any information on the site constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. I am just a random degenerate sensei sharing an opinion.