How Do Automated Market Maker (AMM) Models Like Uniswap’s formula Affect Slippage?

Automated Market Makers (AMMs) have changed the way individuals exchange cryptocurrencies by providing decentralized, constantly available markets. In contrast to conventional exchanges using order books and middlemen, AMMs utilize algorithms and liquidity pools to set prices and execute trades.

Uniswap, among the most widely used decentralized exchanges (DEX), uses an AMM structure that automatically shifts token prices according to supply and demand within the pools. While this technology gives users constant liquidity, it also creates a so-called slippage effect — the disparity between the intended price of a trade and the price at which it actually executes.

Knowing the impact of AMM models such as Uniswap's on slippage is crucial for traders, liquidity providers, and all parties interested in decentralized finance (DeFi). This article deconstructs how slippage works, its causes, and why and how AMM mechanisms have been adapted to reduce its effects.

Understanding Automated Market Makers (AMMs)

What Are AMMs?

AMMs are contracts that enable the direct trading of cryptocurrencies from liquidity pools instead of matching buy and sell orders. LPs put pairs of tokens into these pools, and traders engage directly with the pool to exchange one asset for another.

Each trade alters the balance of tokens in the pool, and the pool adjusts the price of the token accordingly. The simplicity and freedom of AMMs — that anyone can add liquidity and anyone can trade without asking permission — is their elegance.

Principal Features of AMMs

• Infinite Liquidity: Traders can trade at will without requiring a counterparty.

• Permissionless Addition of Liquidity: Anyone can add liquidity and receive fees.

• Transparency: All actions and all pricing mechanisms are controlled by public smart contracts.

• Algorithmic Pricing: Token prices fluctuate automatically after every trade depending on pool balance.

This mechanism for automatic price correction is what creates slippage — a salient feature of AMM-based trading.

What Is Slippage?

Slippage is the disparity between the price you anticipate when opening a trade and the price you receive when it fills. It is an inherent consequence of the operation of AMMs.

When a trader exchanges tokens, the transaction alters the balance of the pool. This update moves the exchange rate since AMMs constantly reprice based on liquidity available. Large trades or low liquidity pools induce more significant price movement, which leads to greater slippage.

For example, when a person purchases a token in bulk from a limited pool, it reduces the supply of that token and raises its price immediately. The trader thus pays a little extra per additional token — the very mechanism that creates slippage in decentralized markets.

Why AMMs Such as Uniswap Suffer Slippage

Uniswap's design ensures that there is always liquidity available, even for small or less in-demand tokens. This does come with a cost, however: price sensitivity. Every trade directly influences the composition of the pool, and thus the token price.

In traditional markets, several orders across various price levels soak up trades incrementally. In AMMs, there is one liquidity pool that contains all available liquidity, and its token ratio dictates price movement. Large trades displace prices more squarely because they alter the pool's ratio more dramatically.

Slippage in AMMs, therefore, is not created by inefficiency but by design — it's the expense of ensuring continuous liquidity.

Variables Affecting Slippage in AMMs

There are a number of factors that determine the amount of slippage at the time of a transaction on decentralized exchanges:

1. Relative Trade Size to Pool Size

The most obvious factor is how big your trade is versus the overall liquidity in the pool. Small trades typically have insignificant slippage since they do not impact the pool's balance significantly. Large trades, on the other hand, have a far larger impact and result in greater slippage.

2. Depth of Liquidity Pool

Large liquidity pools (those with significant quantities of both tokens) can be better absorbed by trades, and prices are maintained stable. Shallow pools have more drastic price fluctuations with each trade.

3. Market Volatility

In times of high volatility, price fluctuations outside the pool will make the token ratio diverge rapidly and produce volatile slippage upon executing a transaction.

4. Network Congestion

Because blockchain transactions are slow to confirm, the pool price may shift between when you enter your trade and when it is executed. Slippage can be exacerbated by this latency, particularly under heavy network loads.

5. AMM Design and Fee Structure

Different AMMs use varied mechanisms for liquidity management. Some impose dynamic fees that adapt to volatility, helping to offset slippage. Others introduce models like concentrated liquidity, which localize liquidity around active price ranges to make swaps more efficient.

How Slippage Occurs Step-by-Step

To understand this better, let’s break it down in simple steps:

1. Trade Quotation: A trader sees the current token price and decides to execute a swap.

2. Transaction Broadcast: The exchange is broadcast to the blockchain network to be confirmed.

3. Pool Adjustment: The transaction alters the token ratio of the pool, automatically adjusting the price.

4. Market Activity: If other traders engage with the pool before confirmation, prices can change even further.

5. Execution: The exchange settles at a slightly different price, usually higher or lower than intended — that discrepancy is slippage.

Slippage is not always bad; it's just an indication of how liquidity dynamically adjusts in decentralized settings.

How Uniswap's Model Influences Slippage

Uniswap's AMM model depends solely on the liquidity pool balance to set prices. Such a mechanism implies the token price is always a derivative of the amount of liquidity left after each swap.

The important point here is that concentration of liquidity dictates sensitivity to slippage. If a pool is short of funds, even a minimal trade moves prices substantially. On the other hand, pools with greater liquidity have more stable prices since the ratio moves less per trade.

This concept became a focal point in Uniswap's development. While initial iterations distributed liquidity equally among all prices, Uniswap v3 brought concentrated liquidity, where providers could deposit around specific price ranges. This optimized markets and significantly minimized average slippage for the majority of trades.

Comparing Uniswap v2 and Uniswap v3