Glossary
Token Swap
What is a Token Swap?
A token swap is a process where one cryptocurrency is exchanged for another. This can occur on centralized exchanges (CEXs) and decentralized exchanges (DEXs), involving either different or the same blockchain technologies. Swapping tokens can be used for various purposes, such as trading, fundraising, or migrating to a new blockchain.
Migration to a new blockchain or network upgrade can also involve a token swap. In this case, users exchange old tokens for new ones on the upgraded network.
Swapping tokens requires , which sellers and buyers provide on exchanges. Low liquidity can result in , where the price of the token changes significantly during the swap. Larger swaps on illiquid markets can lead to price manipulation and unfavorable exchange rates.
The fees for token swaps vary depending on the exchange and the blockchain. Centralized exchanges charge trading fees, while decentralized exchanges may have lower fees but higher gas costs due to blockchain transactions. Users should consider the fees and liquidity when choosing an exchange for token swaps.
Token Swap — Key Concepts
- Exchange Rate: The ratio at which one token can be exchanged for another. The exchange rate is determined by supply and demand in the market.
- Liquidity: The availability of tokens for trading on an exchange. High liquidity reduces slippage and ensures that trades can be executed quickly.
- Market Order: A type of order that executes immediately at the best price. Market orders are used when speed is more important than price.
- Limit Order: A type of order that specifies the price at which a trade should be executed. Limit orders are used to control the price at which a trade occurs.
- Decentralized Exchange (DEX): An exchange without a central authority or intermediary. DEXs allow users to trade directly with each other using smart contracts.
- Centralized Exchange (CEX): An exchange operated by a central authority or company. CEXs match buyers and sellers and facilitate trades on their platform.
- Gas Fees: The cost of processing transactions on a blockchain. Gas fees are paid to miners or validators to include transactions in a block.
- Slippage: The difference between the expected price of a trade and the actual price at which the trade is executed.
- Slippage Tolerance: Maximum acceptable difference between the expected price and the executed price of a trade.
Swapping Tokens on an Exchange
The most common way to swap tokens is through a cryptocurrency exchange. Centralized exchanges like Binance, Coinbase, and Kraken allow users to purchase and sell tokens using fiat currency or other cryptocurrencies.
Swap is often used interchangeably with ‘trade’ on exchanges. Users can swap tokens by selecting the trading pair they want to exchange, specifying the amount, and executing the trade. Centralized exchanges use order books to match buyers and sellers, where users can set the price at which they are willing to buy or sell tokens.
Swaps Using Order Books
Order books on exchanges display the buy and sell orders for a particular token. The order book shows the price and quantity of tokens available for trading. Sellers and buyers can place orders on the order book to buy or sell tokens at a specific price.
A trade is executed when a buy order matches a sell order, and the tokens are swapped between the parties. Users can place different orders on an exchange, such as market and limit orders.
Market Orders vs. Limit Orders
Market orders execute immediately, while limit orders specify the price at which a trade should be executed. Market orders are used to buy or sell tokens instantly. They are executed following the order book’s best available price. The price paid for a market order varies depending on the liquidity and order book depth.
Limit orders use a specified price to control the execution of a trade. The trade is executed if the market price reaches the limit price set by the trader. Limit orders can be used to buy tokens at a lower price or sell tokens at a higher price than the current market price. This trade can take longer or may not be executed if the market price does not reach the expected level.
Swapping Tokens on a Decentralized Exchange (DEX)
Decentralized exchanges (DEXs) run on blockchain networks. Instead of using a central authority to match buyers and sellers, DEXs use smart contracts to facilitate trades directly between users. DEXs give users more control over their funds and privacy, as they do not require users to deposit their tokens on a centralized platform.
While some DEXs use order books like centralized exchanges, others rely on automated market makers (AMMs) to determine token prices. AMMs use liquidity pools to set token prices based on the ratio of tokens in the pool. Users can swap tokens on DEXs by interacting with smart contracts and providing liquidity to the pools.
The price of a token on a DEX is determined by the ratio of tokens in the liquidity pool. When users swap tokens on a DEX, they pay a fee to liquidity providers for facilitating the trade. The fee is distributed among liquidity providers based on their pool share.
Liquidity Pools and Automated Market Makers
Decentralized exchanges allow instant token swaps through automated market makers (AMMs). Liquidity providers are incentivized to deposit tokens into liquidity pools to facilitate trades. When users swap tokens, they pay a fee to liquidity providers for their service.
AMMs use a mathematical formula to determine token prices based on the ratio of tokens in the pool. The most common AMM model is the constant product formula, which ensures that the product of the token balances remains constant. This model allows users to swap tokens without needing a counterparty to match their trade.
Constant Product Formula
Instead of matching buyers and sellers, AMMs use the constant product formula to set token prices.
The formula for the constant product AMM is:
[ x \cdot y = k ]
Where:
- (x) is the quantity of Token A in the pool.
- (y) is the quantity of Token B in the pool.
- (k) is the constant product of the token balances.
Considering a pool with 100 tokens of A and 1,000 tokens of B, the constant product is 100,000. If a user exchanges 10 tokens of A for B, the user will receive approximately 90.91 tokens of B for 10 tokens of A. The next swap will use new x and y values based on the previous trade.
AMM Price Calculation
The new price of a token in an AMM is calculated based on the constant product formula. When a user swaps tokens, the new token balance is calculated using the formula:
[ (x + \Delta x) \cdot (y - \Delta y) = k ]
Where:
- (x) is the quantity of Token A in the pool.
- (y) is the quantity of Token B in the pool.
- (\Delta x) is the quantity of Token A being swapped.
- (\Delta y) is the quantity of Token B being received.
Considering the previous example, the new price of token B after swapping 10 tokens of A is calculated as follows:
[ (100 + 10) \cdot (1,000 - y) = 100,000 ]
[ 110 \cdot (1,000 - y) = 100,000 ]
[ 110,000 - 110y = 100,000 ]
[ 110y = 10,000 ]
[ y = \frac10000110 ]
[ y \approx 90.91 ]
The user will receive approximately 90.91 tokens of B for 10 tokens of A. The swap changed the values of x and y to 110 and 909.09.
This mechanism ensures that the price of a token increases as more users buy it and decreases as more users sell it. A trade’s price impact depends on the trade’s size relative to the liquidity in the pool. Higher liquidity allows for larger trades with less price impact.
Slippage in AMMs
The price that users receive when swapping tokens on an AMM may differ from the expected price. This difference is known as slippage. If a pool has low liquidity, the amount of slippage can be significant, resulting in unfavorable exchange rates for users. As one side of the pool is emptied, the price of the token will approach infinity, making it impossible to swap tokens.
Using the same example, if a user attempts to exchange 99 tokens of A for B, the price of B will increase significantly due to the low liquidity in the pool. The user may receive a much lower amount of B than expected, resulting in high slippage:
[ (100 + 99) \cdot (1,000 - y) = 100,000 ]
[ 199 \cdot (1,000 - y) = 100,000 ]
[ 199,000 - 199y = 100,000 ]
[ 199y = 99,000 ]
[ y = \frac99000199 ]
[ y \approx 497.49 ]
The user will receive approximately 497.49 tokens of B for 99 tokens of A.
Considering the initial ratio of 1:10, the user would expect to receive 990 tokens of B for 99 tokens of A. The significant difference between the expected and actual amounts is due to the low liquidity in the pool.
The slippage can be calculated as:
The user experienced a slippage of approximately 49.7% due to the low supply of tokens in the exchange.
Using pools with higher liquidity, trading smaller amounts, and configuring slippage tolerance can help traders minimize slippage.
Arbitrage in AMMs
Arbitrage is the practice of exploiting price differences between different markets or exchanges. If the price of a token on a platform is higher than on another platform, traders can buy the token on the cheaper platform and sell it on the more expensive platform to make a profit. This process helps align token prices across different platforms and reduces price discrepancies.
Price Manipulation and Front-Running
Price manipulation and front-running are risks associated with AMMs. Price manipulation involves artificially inflating or deflating the price of a token to profit from the price difference. Front-running occurs when traders exploit their knowledge of pending transactions to profit from price changes before the transaction is executed.
Since AMMs use mathematical formulas to determine token prices, the price can be manipulated by executing large trades to move the price in the desired direction. The process of front-running involves monitoring pending transactions and executing trades before the transaction is completed, taking advantage of the price change.
Trades can also be sandwiched, where trades are executed before and after a target trade to profit from the price change. In this case, the trader buys tokens before the target trade and sells them after the target trade to profit from the price difference. These practices are often referred to as toxic MEV (Maximal Extractable Value) has an estimated cost of billions of dollars annually.
Stablecoin AMM Price Calculation
are cryptocurrencies pegged to a stable asset like the US dollar. Using the constant product formula to swap currencies with similar values can result in high slippage due to the small price difference between the tokens. This becomes an issue when swapping stablecoins, as the price difference is minimal.
To address this issue, AMMs trading stablecoins often use a combination of formulas to optimize stablecoin swaps.
Curve Finance is an example of a DEX that specializes in stablecoin trading. It uses modified formulas and pools to optimize stablecoin swaps.
Price Oracles
The price of tokens can be influenced by external price information from oracles. Oracles are trusted data sources that obtain internet data and feed it into smart contracts. DeFi applications may use oracles to determine token prices for swaps and other transactions. Price oracles help ensure that token prices are accurate and prevent manipulation.
The frequency and reliability of price updates from oracles can affect the accuracy of token prices. Using multiple data sources and averaging prices can help reduce the impact of inaccurate or manipulated data.
Price oracles are used to ensure that stablecoins remain solvent and maintain their peg to the underlying asset. Collateralized stablecoins depend on oracles to verify the value of the collateral backing the stablecoin.
Swap Fees and GAS Costs
When using a DEX, users must pay two types of fees: swap and gas fees.
Gas fees are paid to miners or validators to process transactions on the blockchain. The fees are used to prioritize transactions and prevent spam on the network. Every transaction on a blockchain network requires gas fees to be processed.
Swap fees are paid to liquidity providers for facilitating trades on the DEX. They are responsible for maintaining liquidity in the pool, ensuring that trades can be executed. Since higher liquidity pools can handle larger trades with less slippage, developers often incentivize liquidity providers with platform tokens or other rewards.
The process of staking tokens in a liquidity pool to earn swap fees is known as yield or token farming. Visit the Token Farming page for more information.
Swap Routes using Aggregators
Getting the best price for a token swap can be challenging due to price discrepancies across different exchanges. To address this issue, there are token swap aggregators that find the best price for a swap by routing trades across multiple exchanges. Aggregators compare prices on different exchanges and execute trades on the exchange with the best rate.
The best price to swap Token A for Token B may not be a direct swap on a single exchange. Instead, the best path may involve swapping Token A for Token C on one exchange and then swapping Token C for Token B on another exchange. These swaps may happen on a single transaction.
Aggregators may use liquidity pools, order books, and other mechanisms to find the best price for a swap.
