How the time-weighted average price can reduce the impact of large trades on the market

Time Weighted Average Price is an algorithmic trade execution strategy commonly used in traditional financial instruments. The goal of the strategy is to achieve an average execution price that is relatively close to the time-weighted average price (TWAP) for the period specified by the user.

TWAP is mainly used to reduce the impact of a large order on the market by breaking it down into smaller orders and executing each one at regular intervals over a period of time.

How TWAP can reduce the price impact of a bulk order

Bids can affect the price of an asset on the order books or the liquidity in the liquidity pools. For example, order books have multiple buy and sell orders at different prices. When a large buy order is placed, the price of an asset increases because all of the cheapest buy orders are filled.

For example, Coin A currently costs $10 and has the following:

• 50 buy orders at $10
• 50 buy orders at $11
• 50 buy orders at $13
• 100 buy orders at $15
• 500 buy orders at $17

Trader A places an order to buy 300 Coin-A tokens at a price of $17. Since the order amount is larger than the cheaper orders, the protocol runs the price points $10, $11, $13, and $15 to fill the order.

However, since the total buy order is not enough to meet all bids at $17, the price of Coin A will persist at that level. That’s a 70% price increase seen mostly on coins with low liquidity. In most cases, the price increase would be less dramatic.

Although most decentralized exchanges (DEXs) do not have order books, they do have automated market makers (AMMs) that adjust a token’s price based on order size and the size of the liquidity pool. Liquidity is sourced from Liquidity Providers (LPs) who contribute a specified amount of a token pair to the pool in return for a reduction in fees.

Because liquidity in decentralized finance (DeFi) is more dispersed than in more established financial markets, the issue of a single transaction having an outsized impact on the market can be more significant. TWAP strategies can potentially solve the price impact problem by, for example, executing trades at 4-5 minute intervals over an hour.

Breaking up the larger orders can give the DEX time to even out price differences within the respective liquidity pools, helping to bring the asset back to its spot price. The strategy can benefit DEXs as larger price impacts can impact token pairs in the liquidity pool.

For example, the cheaper token in the pair may end up with less liquidity, leading to higher slippage (the difference between a trade’s expected price and the actual price at which it is executed). Increased liquidity can enable larger trading volumes for a DEX and provide a better experience for traders.

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Slippage usually occurs due to low liquidity that demand cannot meet, causing an asset’s price to rise. Ran Hammer, vice president of business development at Orbs, a decentralized Layer 1 public blockchain, shared his thoughts on whether TWAP could improve slippage on DEXs.

Hammer told Cointelegraph, “TWAP, done right, can definitely improve slippage and price differentials. Both of these problems occur in DEX when a trade is too large relative to the total liquidity in the pool and has a disproportionate effect.” He continued:

“TWAP strategies can mitigate this problem by creating smaller orders and giving arbitrageurs a short window to close price differentials and rebalance reserves.”

Deg3ntrades, part of the undoxxed development team at SpiritSwap – a decentralized exchange and DeFi platform on Fantom – also shared his thoughts, mentioning decentralized TWAP (dTWAP), the version of TWAP implemented on SpiritSwap.

Deg3ntrades told Cointelegraph, “By design, dTWAP orders break down trades into batches of smaller trades, allowing the user to specify when those trades are executed at regular intervals over a predefined time period. This results in the market being able to absorb and minimize the price impact of large orders across trading pairs suffering from low liquidity.”

“Due to recent events in the market, which are beyond the control of the DeFi community, liquidity shortages are a prominent concern right now, so Orbs could not have found a better time to integrate dTWAP with SpiritSwap.”

Based on the comments above, smaller orders can improve liquidity by reducing the number of tokens exchanged and allowing liquidity pools to be replenished between trading intervals.

How TWAP can automate the dollar cost average process

The term dollar cost averaging (DCA) refers to an investment strategy in which an investor buys an asset or portfolio of assets for a fixed dollar amount (ie $100 per week). The DCA strategy is used when market volatility is high or a trader has a fractional amount they wish to invest at the time.

For example, if the price of Coin B fluctuates every other day for a month, an investor can buy $250 worth of Coin B every week instead of trying to buy at a perfect time. This is because the cost will reach an average price point over time despite the fluctuating price of the asset.

TWAP can be implemented by a merchant to automatically average their orders by dollar cost. The strategy works by placing longer intervals between orders and a larger overall time frame for trades. For example, trades can be placed on a biweekly, weekly, or monthly basis over a few months, a year, or indefinitely.

Decentralized time-weighted average price

Decentralized Time Weighted Average Price is a version of TWAP developed by Orbs for DEXs and AMMs. The protocol allows decentralized trading platforms to spread trades over time and has already been implemented on SpiritSwap DEX.

The dTWAP smart contract uses a “maker” and “taker” system. The manufacturer is the user who places the order on a DEX and can configure the limit price, order intervals and order expiration.

The term “Taker” refers to an independent party that monitors orders submitted by users (makers) on the DEX. The taker tries to find the best way to fill the batch of orders and bid on the same orders if found. Buyers receive a fee for bidding on orders and compete with other buyers who may be bidding on the same orders.

Takers set a fee, with the minimum amount being enough to cover the transaction fee on trades. Validators on the Orbs network, known as “Guardians,” act as takers in the protocol, automatically calculating and bidding on multiple orders for the manufacturer.

dTWAP user experience

The decentralized time-weighted average price protocol has a portable user interface that can be integrated with DEXs. Trades using the protocol can be divided into market orders (executed at current market prices) or limit orders (executed at a specific price or better).

When trades are executed at the current market price, the dTWAP smart contract will do so at the user’s intervals. Regarding limit orders, once a user has set the limit price, trades will only be executed if that price is available in the chosen intervals. The trade will not be placed if the limit price is not available. Because of this, only a portion of an order’s trades may be executed if desired limit prices are not met.

For example, a user sets a limit price of $50 or less for Coin C, with seven intervals over four weeks (28 trades in total). In the second week, the price didn’t reach $50 for three days, so four trades were executed (out of seven this week). So a total of 25 of the 28 trades for the order were executed.

who benefits

TWAP can be beneficial for traders looking to buy into tokens with lower liquidity or to automate their trading process.

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“TWAP has two basic uses that traders benefit from. One is the ability to take large trades or trades in pairs that are long tail and low in liquidity without disrupting the price. Second, it can be used to automate dollar-cost-average strategies (where the trader buys an asset or set of assets on a specific schedule),” Hammer said, continuing:

“TWAP can be used to construct such strategies in a way that requires no additional action from the trader other than ensuring that sufficient funds are available to complete all trades.”

Deg3ntrades stated, “The ability to use TWAP orders not only reduces traders’ risk of being exposed to high slippage/price impact on large orders or when trading pairs with low liquidity, but also opens up a wealth of new trading strategies and poses they are available to more experienced and advanced DeFi users, such as B. Automated dollar cost averaging.”

Decentralized time-weighted average price strategies can improve the experience of both traders and decentralized exchanges. Additionally, the increased liquidity, reduced price impact, and trade automation of dTWAP could also increase engagement between users and DEXs.

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