To arbitrage is to exploit the price difference of an asset or security between two markets for profit. For example, if one bitcoin is selling for $10 on exchange ABC and $12 on exchange XYZ, then an arbitrageur can generate a profit of $2 by purchasing one bitcoin from ABC and selling it at XYZ. Arbitraging can be automated by utilizing sophisticated computer systems and software to monitor prices and conduct high-volume trades that take advantage of even slight differences in prices. Arbitrage is a necessary financial mechanism that keeps prices consistent between different exchanges and wider markets.
Automated Market Maker (AMM)
An automated market maker (AMM) is a fully automated decentralized exchange where trades are made against a pool of tokens called a liquidity pool. An algorithm regulates the values and prices of the tokens in the liquidity pool. Since AMMs do not rely on an active market of buyers and sellers, trades can occur at any time.
Constant Product Market Maker (CPMM)
CPMMis represented by a classic function: x*y = c
where X and Y are reserves of a certain (chosen) asset in the pool, and C is an unchangeable constant. The function establishes the price of a chosen token, meaning if the supply of token X increases, the supply of token Y decreases in order to maintain the constant value C.
Decentralized Exchange (DEX)
A decentralized exchange (DEX) is a financial services platform for buying, trading, and selling digital assets. On a DEX, users transact directly and peer-to-peer on the blockchain without a centralized intermediary. DEXs do not serve as custodians of users' funds, and are often democratically managed with decentralized governance organization. Without a central authority charging fees for services, DEXs tend to be cheaper than their centralized counterparts.
Impermanent loss occurs when the value of tokens held in an algorithmically balanced liquidity pool lose value relative to assets in the open market due to price volatility. The loss is 'impermanent' because the original value of the tokens can be restored if the liquidity pool restores balance.
In regards to an asset, liquidity refers to the ability to exchange an asset without substantially shifting its price in the process, and the ease with which an asset can be converted to cash. The easier it is to convert the asset to cash, the more liquid the asset. With regard to markets, liquidity refers to the amount of trading activity in a market. The higher the trading volume in the market, the more liquid the market. Liquid markets tend to increase the liquidity of assets.
Liquidity Providers (LP)
A liquidity provider is a user who deposits tokens into a liquidity pool. In return for supplying liquidity, users are typically awarded liquidity provider (LP) tokens that represent the share of the liquidity pool the user owns.
Within a financial context, slippage refers to the difference between the expected price of a trade relative to the actual price at which the trade is executed. Slippage generally occurs when an investor buys or sells an asset on a platform with poor liquidity and low trading volume. If there is a large gap between the bid-ask price on an exchange's order book, the asset purchaser may end up paying more for an asset or receive less of the asset than expected once the trade has been executed.