Differences in Trading Mechanisms Between CEX and DEX

Before understanding why the execution price might differ from the expected price, it's important to distinguish the trading mechanisms of centralized exchanges (CEX) and decentralized exchanges (DEX).

CEX Order Book Mechanism

Price Determination: CEX platforms use an order book mechanism where limit orders are executed at the specified price, typically without significant slippage.

Matching System: The order book automatically matches buy and sell orders based on market conditions, enabling instant transactions.

DEX Automated Market Maker (AMM) Model

Pricing Formula: DEX platforms utilize liquidity pools and the "constant product formula" (x * y = k) to dynamically adjust prices.

Price Deviation: Large trades can alter the token ratios in the pool, causing the actual execution price to diverge from the expected price, particularly in situations with low liquidity.

Main Reasons for Price Deviation

Slippage Definition

• Slippage is the difference between the expected price and the actual execution price of a trade.
• Cause: Each trade changes the ratio of tokens in the liquidity pool, and slippage becomes more noticeable when liquidity is low.
• Controlling Slippage: Traders can manage slippage by setting a tolerance range for slippage and choosing liquidity pools with deeper liquidity.

Liquidity Issues Liquidity Depth

• A deep liquidity pool ensures small price changes during transactions, while insufficient liquidity leads to significant price fluctuations.
• Impact of Large Trades: In an AMM model, large trades shift the token ratio, causing the price curve to change.

Gas Fees and Transaction Priority Gas Fees Impact

• Low gas fees can delay a transaction, especially in volatile markets, potentially leading to price deviation.
• Network Congestion: When the network is congested, transaction execution takes longer, which may cause the final price to differ from the expected price.

Ways to Minimize Price Deviation

Choose Liquidity-Rich Pools: Ensure that the liquidity pool has enough assets to support the transaction.

Set a Slippage Tolerance: Set a reasonable slippage tolerance based on the trade volume to prevent excessive deviation or failed transactions.

Prioritize Small Trades: Breaking down large trades into smaller transactions can mitigate the impact of large trades on price.

Use Fast Mode: Opt for fast or priority modes during peak trading times to reduce delays that could cause price deviation.

Characteristics of the AMM Model

Price Fluctuation Curve: Price changes follow a curved distribution, with larger trades resulting in more significant price fluctuations.

PImpact of Large Trades: Large trades magnify price deviation. It’s recommended to break down larger trades to reduce this effect.

Conclusion

The primary reasons for discrepancies between the expected and actual execution prices in limit orders stem from the AMM model's characteristics, insufficient liquidity depth, and issues related to slippage and gas fees. To minimize unnecessary losses, traders should ensure they understand the liquidity status of a pool, set reasonable slippage tolerance, and select appropriate trading modes.