Price Impact: The First ‘Gotcha’ of DeFi Markets
Let’s take an imaginary adventure. Say our friend Khadija has decided to invest in a crypto project. She sees this token that she likes; maybe it’s based off of one of her favorite memes, or maybe it’s part of an on-chain video game that she thinks is going to be really popular; maybe it’s a utility token for a distributed storage network. Whatever the reason, Khadija decides to throw €100 at it. Each token only costs €0.01, so say she’s got 10,000 tokens in her wallet.
Khadija is good at business; the project takes off. There’s buzz about it; it’s a trending topic. The price jumps, to €0.03, and eventually, to €0.10. Khadija now has €1000 worth of tokens, and she decides it’s been fun, but she’s ready to cash out.
So Khadija hops onto MetaMask to exchange her tokens for ETH; but when she gets the ETH, she’s very confused. Instead of the equivalent of €1000 in ETH, she has more like the equivalent of €200. What happened? Did she misunderstand the price of the token? Did the swap platform charge her some enormous fee? Was it the gas prices?
While it’s always a good idea to check out the gas price before you do something on Ethereum, and understand what a dapp is doing when it interacts with you, what happened to Khadija in this imaginary scenario is that the very action of selling her 10,000 tokens caused the value of the tokens to drop.
Price Impact Happens With Low Liquidity
This is what is known as price impact. On its face, it doesn’t seem logical; the tokens had a price. Khadija sold the tokens for that price, she should get in return the value of the number of tokens times their price. So why the bait-and-switch?
Well, it’s not a bait-and switch. It has to do with how an asset market works, and how much liquidity is in the pool of assets that you’re trading. The same thing can happen in traditional finance markets, as well; if you make a large-volume trade, you max out some of the more advantageous orders ‘on the books’, and then whatever is left over of your trade is executed at a worse price (for you, at least).
To think about it in more general terms: we’re talking about supply and demand. Khadija, in one moment, is changing the supply of tokens by +10,000. If the entire pool of tokens she’s trading in only holds 100,000, that’s a significant adjustment to supply, and generally, if there’s a greater supply of something, its value is diminished.
Partially, this is because Khadija’s token, while it’s gaining in popularity, isn’t widely established, and doesn’t have a lot of people trading it. If there were more demand, and more liquidity in the market, then there would be more people buying and selling at stable price points, and Khadija’s sale of 10,000 tokens wouldn’t make that much of a ripple in the liquidity pool.
Woah. How do I make sure I get the value I want out of my tokens?
First of all, price impact is yet another reason to be cautious when dabbling in new, unestablished tokens. If you are interested in buying or selling a given token, then there are a few things to consider:
- Volume. Are you moving significant amounts of the token? Take a look at the contract address of the token in a block explorer like Etherscan, and see how much other people are moving. Are you about to move a lot more than the average transfer? If you’re just buying or selling “a few”, compared to others, then there’s probably not much reason to worry.
- Pool depth. This is where it gets tricky, especially with new tokens; often, they’re such recently-created projects that they haven’t been picked up by the larger trading platforms. In fact, you might be restricted to trading them on a specific platform or dapp. It would be safer if you could find a pool on a large, well-recognized and reputable trading platform that has a lot of liquidity in the pool. Think back to the explanation about supply and demand.
- Use an aggregator. If you can, find an aggregator that trades your token, especially an aggregator that specifically looks out for, and automatically warns you, about price impact, such as MetaMask Swaps. And, it goes without saying, if the aggregator warns you about potential price impact, pay attention!
If you’ve been around the crypto world for any amount of time, you should have known this was coming: this article does not constitute financial advice. If anything, what the take-away from this article should be is: “DeFi is just as complex as traditional financial markets; in fact, perhaps more so due to its novelty, and engaging in it can be a risky business, even if you know what you’re doing.”
Stay safe out there. And come back for the second installment of the ‘Gotchas of Financial Markets’: the dreaded impermanent loss.
This is part of an ongoing series of posts designed to explain the world of Web3 and orient users as to how to use it, and how to use it safely. We’ll be covering topics ranging from the technical to the humorous. Follow along and you’ll be a savvy, safe MetaMask power user in no time. Check out our first post on what a self-custody wallet is.