Are my tokens worth 69 ETH? Or only 0.1337 ETH?

I look at the order book, and it says 'well, you know, you can buy one at one cent. And you can sell one at $1'. So is the price one cent or is the price $1? I don’t even know. I don’t, and neither does anybody else. If the spread is one cent to $1, there’s no way to know where are the “actual” prices. I put in an order at two cents, and itt was above the actual price — my order order is going to fill right away. I bought in at two cents and no one ever wants to buy it from me for more than a cent. I’ve already overpaid 100% for the token.

Or I put an order in at two cents, and it will sit there. I check back every couple of days and see if any of it filled. I actually want to get into this, so every couple of days I raised the price a cent. But if it’s a really thin market, no one is actively trading it. I’m raising the price, increasing my bid every couple of days to get into the position. I might shoot way past the actual price or the fair market price before somebody notices that I’m raising my bids every day, and comes in and sell some of it to me. Or they might notice and say “oh this guy is raising his bids every day I wonder how high he will go”. I get all the way to 99 cents and then they fill it at 99 cents. It drops back to a cent, because there’s no bids below mine, and then I can never sell it. I’ve overpaid 9800%.

This is obviously not ideal, especially for the long tail of thinly traded assets, where you can only get a couple of thousands dollars worth without moving the price plus or minus two percent. Or in this case, plus or minus thousands of percent. Or I might never be able to get into the position that I want because I’m not willing to raise the price more than 20 cents and there’s no liquidity. So this is a very far from ideal situation.

Automated Market Makers (Liquidity Pools)

As the cryptocurrency ecosystem matured, people started thinking there are other ways to do decentralized exchange without order books. Eventually Uniswap developed their ‘constant product’ ( x * y = k ) market maker mechanism. I won’t go too deep into the math here. Both tokens are put in a pool, and it maintains the price to be whatever value will hold both sides of the pool to be equal. When someone trades, the quantity of tokens in either side changes, so the price changes. There’s always at least as much liquidity as people put in the pool.

It worked, and projects could submit their own liquidity pools. If you provide liquidity, you earn market maker fees, and sometimes projects will incentives liquidity with additional rewards (yield farming). So that proved to be a much more elegant solution for liquidity provision for this long tail of thinly traded crypto assets, and it became the standard for decentralized exchange on Ethereum and most every blockchain that can support the required token standards and smart contracts.

Some Trading Implications

In my post two weeks ago, I mentioned that all of the liquidity providers in a liquidity pool are makers, and every trade against the liquidity pool is a taker. The liquidity pool replaced this order book design, and the liquidity providers (LPs) are effectively making a market at any particular price on both sides of the market price. Their liquidity provision is essentially spread out at every potential price, so how much liquidity you can get will still depend on how much you’re willing to push the price — on how much market depth there is.

If you understand the difference between order books versus liquidity pools, then you can look at specific markets and have a better understanding of how price might behave, based on whether the market depth is primarily liquidity pools or order books.

If the only liquidity for a token is an order book, then the market depth might be irregular. Let’s say that there’s 1000 HIVE available at 40 cents. There’s only 10 HIVE available at 41 cents, and then there’s 100,000 HIVE available at 42 cents. That’s a very irregular orderbook. I could buy 1000 and barely move the price. Then buying anywhere between 1010 and 100,000 will push the price the exact same amount!

If the token is traded in liquidity pools, then the market depth is very regular, almost the same for either buying or selling. Buying a higher quantity will go deeper into the market depth (more slippage) but in a predictable way.

A Quick Warning — Front Running Bots

In both cases, when you’re trading on a decentralized exchange, other market participants will be able to see your orders before they are recognized by the exchange. There are bots that evaluate your orders and may potentially manipulate the markets you’re trading in to extract excess profits from your activity.

Depending on what the fees are on the blockchain that you’re using, you may want to break a large order up into smaller pieces. If your order would push the price by 5%, then as soon as you submit that order you’re going to be front run by a bot. They’re going to push the price up 5% first, your order is going to fill and push the price up another 5%, and then they’re going to sell the crypto that they just bought and push the price back down. You’re immediately going to get an above market price, 5% above what you intended for it to be.

The easiest way to avoid that is to make sure that you set your order to limit the slippage. Your order is not allowed to execute if the price goes above a certain point. Set that slippage level, and break up your order into smaller pieces. I never, ever, ever do orders that push the price more than 1% because I know that if I do an order that pushes it more than 1% it’s going to get front run. I will usually trade even smaller than that.

Conclusion

The liquidity ‘behaves’ differently in order book markets and liquidity pool markets. Order book liquidity is mostly provided by active market maker bots, while liquidity in pools is provided by passive LP participants. There are always bots hiding in the shadows that may take action if you don’t structure your orders carefully, but if you trade carefully you can minimize your risks to an acceptable level.

My hope is that a better understanding of market structure can help you to better evaluate how new markets are likely to behave. Knowledge creates opportunities!

If this has been informative to you, please share with a friend! If it was all review, but you know somebody that really needs to understand these concepts, pass it on gently.

Not financial or tax advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. This newsletter is not tax advice. Talk to your accountant. Do your own research.

Disclosure. From time-to-time I may add links in this newsletter to products I use. I may receive commission if you make a purchase through one of these links. Additionally, the Savage Corner writers hold crypto assets and actively trade in certain markets.

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