Token Swap

An Automated Market Maker (AMM) is a smart contract that holds liquidity reserves (pools) and algorithmically sets token prices based on a constant function, such as x * y = k. This eliminates the need for traditional order books, allowing for permissionless, 24/7 trading.

• Key Formula: The Constant Product Formula (x * y = k) dictates that the product of the quantities of two tokens in a pool must remain constant.
• Example: Uniswap V2 and PancakeSwap pioneered this model, enabling anyone to become a liquidity provider.

A liquidity pool is a smart contract that holds paired deposits of two tokens, forming the trading pair's reserves. Users (liquidity providers) deposit an equal value of both assets to facilitate swaps and earn a portion of the trading fees.

• Function: Provides the capital depth for swaps to occur without a counterparty.
• Incentive: Providers earn fees (e.g., 0.3% per trade) proportional to their share of the pool.
• Risk: Exposure to impermanent loss if the price ratio of the deposited assets changes significantly.

Slippage is the difference between the expected price of a trade and the executed price, caused by market movement and low liquidity. Slippage tolerance is a user-set parameter (e.g., 0.5%) that defines the maximum acceptable price deviation; transactions failing this condition are reverted.

• Cause: Large orders in shallow pools can move the price along the AMM curve.
• Mitigation: Setting a lower tolerance protects against unfavorable trades but may cause transaction failures during high volatility.

Swap aggregation is the process of splitting a single trade across multiple liquidity pools or DEXs to achieve the best possible exchange rate (lowest slippage, highest output). Aggregator protocols like 1inch and Matcha perform this optimization automatically.

• Method: Algorithms find the optimal path, which may involve multiple hops (e.g., ETH → USDC → DAI) or different DEX venues.
• Benefit: Maximizes capital efficiency for the trader by sourcing liquidity from the entire ecosystem.

Gas fees are the computational cost of executing a swap on-chain. Optimization techniques are critical for cost-effective trading, especially on Ethereum.

• Gas Tokens: Historically used to store gas when prices are low (largely deprecated post-EIP-1559).
• Batch Transactions: Aggregators bundle multiple user swaps into one transaction to distribute gas costs.
• Layer 2 & Alt-L1s: Swaps on networks like Arbitrum, Optimism, or Solana offer significantly lower base fees.

Price impact measures how much a swap moves the market price within a liquidity pool, expressed as a percentage. It is a direct function of trade size relative to pool depth.

• Calculation: A large buy order for Token A will deplete its reserves in the pool, increasing its price according to the AMM formula.
• Rule of Thumb: Higher liquidity (Total Value Locked) results in lower price impact for standard trade sizes. Traders should always check this metric before executing.

Impermanent loss is not a security breach but a fundamental financial risk for liquidity providers (LPs). It occurs when the price ratio of the two tokens in a liquidity pool changes after deposit. LPs can end up with a portfolio value less than if they had simply held the tokens. The loss is 'impermanent' only if prices return to the original ratio. Key factors influencing IL include:

• Volatility: Higher volatility increases potential IL.
• Divergence: The greater the price divergence, the greater the loss.
• Fee Revenue: High trading fees can offset IL, but do not eliminate the risk.

Slippage is the difference between the expected price of a trade and the executed price, caused by insufficient liquidity or large orders. Price impact measures how much a trade moves the market price within a liquidity pool. High slippage can be exploited through price oracle manipulation or flash loan attacks to drain pools. Users must set appropriate slippage tolerance limits in their swap interfaces, but setting it too low can cause transaction failures, while setting it too high increases exposure to malicious trades.

A rug pull is a malicious event where developers abandon a project and withdraw all liquidity, rendering the token worthless. There are two primary types:

• Hard Rug: Developers remove liquidity pool funds directly, often possible if they retain control of the liquidity pool (LP) tokens.
• Soft Rug: Developers sell off their large token holdings, crashing the price, often enabled by hidden mint functions or disproportionate token allocations. Red flags include anonymous teams, unaudited contracts, locked liquidity with short timers, and excessive ownership concentration.

The security chain extends beyond the protocol to the user's interface and wallet. Key risks include:

• Malicious DApp Interfaces: Fake websites that mimic legitimate DEXs to steal wallet approvals and private keys.
• Approval Exploits: Granting unlimited token approvals to a malicious or compromised contract can lead to complete asset drainage.
• Wallet Drainers: Malicious scripts embedded in sites that trigger transactions to steal funds.
• Centralized Points of Failure: Reliance on specific RPC providers or indexers for price data and transaction broadcasting can be a single point of failure or censorship.

The difference between the expected price of a trade and the actual executed price. In token swaps, slippage occurs because each trade changes the pool's reserves, moving the price. It is influenced by:

• Trade Size: Larger swaps cause more price impact.
• Pool Depth: Pools with higher Total Value Locked (TVL) experience less slippage.
• Volatility: Rapid price movements can cause quotes to expire before execution. Traders set a slippage tolerance (e.g., 0.5%) to limit unfavorable executions.

A percentage charge deducted from each token swap, which is distributed to the Liquidity Providers of the pool. This fee compensates LPs for impermanent loss risk and provides the yield for liquidity mining. Typical fees range from 0.01% for stablecoin pairs (Curve) to 0.3% for standard volatile pairs (Uniswap V2). The fee is automatically factored into the swap calculation and added to the pool's reserves.