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Decentralized Finance, or DeFi, is rapidly reshaping the financial landscape, offering a permissionless and transparent alternative to traditional banking. Built on the revolutionary blockchain technology, DeFi aims to empower individuals by removing intermediaries and placing control back into the hands of users. For those embarking on their DeFi journey, understanding the foundational terminology is crucial. This guide breaks down the essential concepts and terms you'll encounter in this innovative space.

### The DeFi Foundation: Core Concepts Unpacked

At its essence, DeFi champions decentralization, meaning power and decision-making are distributed across a network rather than residing with a single entity. This is made possible by the blockchain, a secure, distributed, and immutable ledger that records all transactions, ensuring transparency and integrity.

The true workhorses of DeFi are smart contracts. These are self-executing agreements, with the terms directly embedded in code on the blockchain. They automate processes, enforce rules, and eliminate the need for third parties, fostering a trustless environment where users rely on code, not institutions. The inherent permissionless nature of DeFi means anyone with an internet connection can access and utilize these protocols without needing approval.

One of DeFi's most exciting characteristics is composability, often referred to as "money legos." This signifies the ability of different DeFi protocols to seamlessly connect and build upon one another, enabling the creation of complex and innovative financial services. This modularity fuels rapid innovation within the ecosystem.

### Navigating the DeFi Ecosystem: Key Components and Services

The DeFi landscape is rich with applications and services designed to replicate and enhance traditional financial offerings:

-   **dApps (Decentralized Applications):** These are software applications that run on a decentralized blockchain network, typically powered by smart contracts.
    
-   **DEXs (Decentralized Exchanges):** Unlike centralized exchanges, DEXs enable peer-to-peer trading of digital assets without an intermediary holding funds. Many DEXs utilize AMMs (Automated Market Makers), which rely on algorithms and liquidity pools to facilitate trades.
    
-   **Liquidity Pools:** These are collections of digital assets locked within a smart contract to enable trading on DEXs. Users who contribute assets to these pools are called Liquidity Providers (LPs) and earn a share of the trading fees.
    
-   **Yield Farming (Liquidity Mining):** A popular strategy where users contribute assets to DeFi protocols to earn rewards in the form of tokens or fees, often by strategically moving assets across different protocols to optimize returns.
    
-   **Lending & Borrowing Protocols:** These platforms allow users to lend their cryptocurrency to earn interest or borrow assets by providing collateral. DeFi loans are often over-collateralized to mitigate price volatility.
    
-   **Stablecoins:** Designed to maintain a stable value, stablecoins are typically pegged to a fiat currency (like the USD) or other stable assets, reducing price fluctuations. Popular examples include USDT, USDC, and DAI.
    
-   **DAOs (Decentralized Autonomous Organizations):** These organizations operate under rules encoded in smart contracts, with governance decisions often made by token holders through a voting process.
    
-   **Oracles:** Crucial for DeFi, oracles are external data feeds that bring real-world information (e.g., asset prices) onto the blockchain for smart contracts to use.
    
-   **Gas Fees:** These are the transaction fees paid on blockchain networks (e.g., Ethereum) to compensate network participants for processing and validating transactions.
    

### Understanding Digital Assets in DeFi

Various types of digital assets drive the DeFi ecosystem:

-   **Fungible Tokens:** Interchangeable tokens where each unit is identical (e.g., Ether (ETH), Bitcoin (BTC)).
    
-   **Non-Fungible Tokens (NFTs):** Unique digital assets where each token is distinct and non-interchangeable (e.g., digital art, collectibles).
    
-   **Governance Tokens:** These tokens grant holders voting rights in a protocol's governance, allowing them to participate in its future development and decision-making.
    
-   **LP Tokens (Liquidity Provider Tokens):** Received by liquidity providers, these tokens represent their share and claim on assets within a liquidity pool.
    
-   **Wrapped Tokens:** A cryptocurrency token on one blockchain that represents another cryptocurrency from a different blockchain (e.g., Wrapped Bitcoin (wBTC) on Ethereum), enabling interoperability.
    

### Essential Tools and Considerations for DeFi Users

To engage with DeFi, a wallet is indispensable - it's a software application or hardware device for securely storing your cryptocurrencies and interacting with dApps. Your private key is the cryptographic key that grants you access to your funds and data; it must be kept absolutely secret. Your public key, often referred to as your wallet address, is what you share to receive funds.

Other important terms to be aware of include:

-   **Slippage:** The difference between the expected price of a trade and the price at which it is actually executed, often due to market volatility or low liquidity.
    
-   **TVL (Total Value Locked):** The total amount of digital assets locked within a DeFi protocol, serving as a key metric for its size and adoption.
    
-   **Flash Loan:** An uncollateralized loan that is borrowed and repaid within the same blockchain transaction, often used for arbitrage opportunities.
    
-   **Aggregator:** A DeFi protocol that scans multiple platforms to offer users the best rates for various services, such as lending, borrowing, or swapping.
    

While DeFi presents exciting opportunities for financial innovation and inclusion, it's crucial to understand the inherent risks, including smart contract vulnerabilities, market volatility, and the nascent regulatory environment.

By grasping these fundamental terms, you'll be well-equipped to explore the dynamic and rapidly expanding world of Decentralized Finance.

  

## CoW Protocol Glossary

  

Now that you’ve grasped the basics, here are some CoW specific terms that can help you navigate the CoW ecosystem.

  

**[CoW Swap](https://cow.fi/cow-swap)** - What started it all. CoW Swap is our version of what a DEX should look like: a powerful, open-source, and permissionless DEX aggregation protocol that anyone can integrate for a variety of DeFi purposes. It provides MEV protection, a simple user interface, advanced trading tools across multiple networks, all wrapped up in one ;

  

**[CoW Protocol](https://cow.fi/cow-protocol)**  - the backbone of the CoW world. It’s the leading intents-based DEX aggregation protocol. What does that mean? It leverages intents, batch auctions, and the largest solver network in DeFi to bring surplus-capturing, MEV-protected trades to users. It’s our secret sauce.

  

**[CoW AMM](https://cow.fi/cow-amm)** - our very own automatic market maker (AMM) but with a twist. This is the first MEV-capturing AMM, it protects LPs from LVR so they can provide liquidity with less risk and more return.

  

**[CoW Widget](https://cow.fi/widget)**  - The widget is the simplest way you can integrate CoW Swap on your platform. If you want to bring seamless, MEV-protected trading to your website or dApp (and add an extra revenue stream in the process), this is the fastest way to do it.

  

**[CoW Explorer](https://explorer.cow.fi/?utm_source=cow.fi&utm_medium=web&utm_content=menubar-nav-item-cow-explorer)** - a handy little tool that lets you explore any order ID, ETH Address, ENS Address or Tx hash.

## Specific terms we use around here

  

There are a few unique terms you might see in our documents and our project pages that might seem technical at first glance. Below we break down some of the most common ones.

  

**Intent to Trade:** When users submit orders on CoW Swap, they are not actually initiating a blockchain transaction, like they would on Uniswap. Instead, orders are submitted as signed “intent to trade” messages which include the details of the intended trade, but are not actually submitted to the blockchain. From here, independent parties known as “[solvers](https://docs.cow.fi/cow-protocol/tutorials/solvers)” find the best execution path for the specified trade and execute the trade on-chain on behalf of the user. If a trade route cannot be found for any reason, the transaction will not execute and the user will not be charged a fee for the failed transaction.

**Delegated trade execution:** When it’s time to actually execute a settlement (which can contain multiple trades), [solvers](https://docs.cow.fi/solvers/solvers) lock in the execution path and submit the transaction to the blockchain.Note here that it is the solvers who are completing the transaction on behalf of the user, meaning that they determine the correct slippage tolerance to use, the right amount of gas fees, as well as taking on the risk of negative price movements or MEV.

The delegated trading model also means that traders using CoW Swap do not have to spend ETH to cover gas. Instead, gas fees come out of the sell token when making trades.

**AMM:** Automated Market Makers, also known as “DEXs,” are trading mechanisms that allow traders to buy and sell assets in real-time. Unlike traditional “orderbook” trading, which relies on counterparties for every transaction (you need a seller in order to buy and a buyer in order to sell), AMMs work by maintaining a constant ratio between the prices of two assets. For example, ETH and COW. AMMs use the formula “x*y = k” to determine a fair price based on the ratio between two assets (x and y) in the liquidity pool.

Any time a trade alters this ratio by depleting the supply of one asset and increasing the other, the prices of the assets adjust in order to preserve the established ratio. For instance, if a trader buys COW and sells ETH, the COW price rises and the ETH price falls. The opposite happens when traders sell COW and buy ETH.

**Price Impact:** Crypto markets, like all markets, are based on supply and demand. AMMs maintain “liquidity pools” of assets which they use to fill trades. Each trade drains some amount of this liquidity and moves the asset's price. This price movement is known as “price impact.”

The larger the trade, the bigger the price impact. A trade of $100 ETH will not move the price of ETH very noticeably, since it only makes up a tiny fraction of the available liquidity. A trade of $1,000,000 ETH, however, will noticeably move the price of ETH.

**Transaction Reordering:** Blockchain transactions do not always enter the block in the order that they were submitted. Searchers can “bribe” the validators responsible for creating the block to get them to arrange transactions in a specific sequence. This transaction reordering is what makes all of MEV possible.

**EOA Wallets:** Externally owned accounts (EOAs) are Ethereum accounts controlled by private keys. EOA wallets — for example: MetaMask, Rainbow, and Rabby Wallet — allow users to (1) send, hold, and receive Ethereum-native tokens, and (2) interact with smart contracts. Unlike smart contract wallets, EOA wallets are usually generated with a seed phrase and do not have any code associated with them.

**Milkman:** The [Milkman](https://github.com/charlesndalton/milkman) smart contract ensures trades are executed for the real-time price or better by utilizing a price checker, such as a Uniswap pool or an oracle. Instead of setting a fixed slippage tolerance based on the current market price, DAOs can utilize Milkman to determine a maximum percentage deviation from a real-time price sourced from a price checker, guaranteeing that their trade will finalize at a fair market price. If a trade can’t be executed within the defined price or better, the order remains pending until the price condition is met, or until the trader cancels the order.

## The different types of trades available on CoW Swap

  

Last, but certainly not least, some of the trades you can execute on CoW Swap. What they’re called, how they work, why you might want to use them.

-   **[Market orders](https://docs.cow.fi/cow-protocol/concepts/order-types/market-orders)** - buy or sell tokens as soon as possible at the current market rate.
    
-   **[Limit orders](https://docs.cow.fi/cow-protocol/tutorials/cow-swap/limit)** - set your own parameters for how much you are willing to buy and sell.
    
-   **[TWAP orders](https://cow.fi/learn/getting-to-grips-with-time-weighted-average-price-twap-orders)** - allows traders to spread their trade over a specified period of time.
    
-   **[Programmatic orders](https://docs.cow.fi/cow-protocol/concepts/order-types/programmatic-orders#:~:text=CoW%20Protocol's%20Programmatic%20Order%20Framework,elapsed%2C%20and%20much%20more)** - create conditional orders that execute when certain on-chain conditions are met (such as asset prices, wallet balances, time elapsed, and much more)
    
-   **[Milkman orders](https://cow.fi/learn/what-is-milkman-cow-swaps-solution-for-delayed-execution-trading)** - delayed execution trading: set and forget your trades for optimum conditions.
    
-   **[CoW Hooks](https://docs.cow.fi/cow-protocol/concepts/order-types/cow-hooks)**  - allow users to pair any Ethereum action (or set of actions) with an order on CoW Protocol, leveraging the [solvers](https://docs.cow.fi/cow-protocol/concepts/introduction/solvers) to execute the actions together in the sequence.
    

## In summary

  

DeFi can often feel like it thrives on complexity. But in reality, many of the tools and systems that have been built were imported from the world of trad-fi, reimagined and renamed into something new. The language might be new, but the ideas have been around for a long time.

  

By mastering these terms, you can start to understand how the world of DeFi works, and how to navigate safely, and securely.

  

## Next Steps

Ready to experience the power of DeFi for yourself? Head over to [CoW Swap](https://swap.cow.fi/#/1/swap/WETH/0xA0b86991c6218b36c1d19D4a2e9Eb0cE3606eB48) and try a trade!

**Related Reading:**

-   [How Money Flows in DeFi: Unpacking the Decentralized Financial System](https://cow.fi/learn/how-money-flows-in-de-fi-unpacking-the-decentralized-financial-system)
    
-   [Understanding DeFi Lending](https://cow.fi/learn/understanding-defi-lending)
    
-   [Finding the Right DEX for You: Why DEXes Aren’t All Built the Same](https://cow.fi/learn/finding-the-right-dex-for-you-why-de-xes-aren-t-all-built-the-same)

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For those embarking on their DeFi journey, understanding the foundational terminology is crucial. This guide breaks down the essential concepts and terms you'll encounter in this innovative space.

Diving Deep into Decentralized Finance: Your Comprehensive Guide to DeFi Key Terms

You've dipped your toes into DeFi, maybe even done a swap or two. Perhaps you've moved some ETH for USDT, or jumped into a hot new meme coin. But have you ever stopped to think about how those swaps actually happen, and why some decentralized exchanges (DEXs) feel different from others?

DEXs are the backbone of DeFi, allowing us to trade crypto directly from our wallets without needing a middleman. It's the ultimate promise of decentralization, putting you in control. But just like cars, they come in many models, each with its own engine, features, and quirks. Choosing the right one for your trading style can make a huge difference in terms of price, gas fees, and overall experience.

In this article, we'll demystify the different types of DEXs, explore their pros and cons, and shine a spotlight on a particularly innovative one: [CoW Swap](https://swap.cow.fi/?utm_source=cow.fi&utm_medium=web&utm_content=menubar-nav-button-trade-on-cow-swap#/1/swap/USDC/COW). Our goal is to help you navigate the DEX landscape with confidence and find the perfect fit for your trading needs.

## The Basics: What Exactly is a DEX, Anyway?

Before we dive into the nuances, let's quickly recap what makes a DEX, well, a DEX.

You're probably familiar with Centralized Exchanges (CEXs) like Coinbase or Binance. Think of them like traditional banks or stock exchanges. You deposit your funds, they hold them, and they facilitate trades. They're often easier to use and boast high liquidity. The trade-off? You're trusting them with your assets ("not your keys, not your crypto"), and you'll typically go through KYC (Know Your Customer) checks.

A DEX, on the other hand, lets you trade directly from your own self-custody wallet (like MetaMask or Rainbow). Smart contracts handle all the magic, executing trades directly between users. This means you retain full control over your funds, enjoy censorship resistance, and benefit from greater privacy. The "no intermediary" promise is powerful, giving you true peer-to-peer trading.

We’ve written a whole article on the difference between the two. [DEXes vs. CEXes: What you need to know](https://cow.fi/learn/dexes-vs-cexes-what-you-need-to-know)

  

## Beyond the Hype: Different Flavors of DEXes

Not all DEXs are built the same under the hood. Here are the main types you'll encounter:

### Automated Market Makers (AMMs): The Liquidity Pool Powerhouses

This is by far the most common type of DEX you'll see. Instead of traditional order books where buyers and sellers place specific prices, AMMs use liquidity pools. These pools are funded by users (called liquidity providers or LPs) who deposit pairs of tokens, like ETH and USDC.

When you swap tokens on an AMM, you're not trading with another individual directly. You're interacting with this liquidity pool, and the price is determined by a mathematical formula (the most famous being x∗y=k). It's like a vending machine for tokens: you put in one, you get out another, and the price adjusts based on how much of each token is left in the machine.

**Pros:** AMMs offer constant liquidity, making them incredibly easy and permissionless to use.

**Cons:** LPs face the risk of impermanent loss, and traders can experience slippage, especially on larger trades or for less liquid tokens, where the price moves significantly during your swap.

**Examples:** Uniswap, PancakeSwap, SushiSwap.

### Order Book DEXes: The Traditionalists of DeFi

These DEXs operate more like traditional exchanges, featuring order books where buyers place "bid" orders (what they're willing to pay) and sellers place "ask" orders (what they're willing to sell for). Trades are matched when a buyer's bid meets a seller's ask.

Imagine a bustling marketplace where everyone shouts out their buy and sell offers. When two offers match, a deal is made.

**Pros:** Order book DEXs offer more precise control over prices with features like limit orders, and they can potentially have less slippage for large orders if the liquidity is deep.

**Cons:** They can sometimes be less liquid than AMMs, and every action (placing, modifying, or canceling an order) often incurs a gas fee, which can add up.

**Examples:** dYdX (which uses a hybrid model), Loopring.

### DEX Aggregators: The Smart Shoppers of DeFi

These platforms don't hold their own liquidity. Instead, DEX aggregators scour multiple DEXs (both AMMs and order books) to find you the best possible price for your trade.

Think of them like a flight comparison website. You input where you want to go, and it shows you the best routes and prices from various airlines. A DEX aggregator does the same for your crypto swaps, splitting your order across different DEXs to minimize slippage and get you the optimal rate.

**Pros:** You get the best available prices, and slippage is often reduced. They're incredibly convenient.

**Cons:** They're still subject to the limitations and gas fees of the underlying DEXs they route through.

**Examples:** 1inch, ParaSwap.

### Enter CoW Swap: A New Breed of DEX

Now, let's talk about something truly special: [CoW Swap](https://swap.cow.fi/?utm_source=cow.fi&utm_medium=web&utm_content=menubar-nav-button-trade-on-cow-swap#/1/swap/USDC/COW). It's built on CoW Protocol, which takes a fundamentally different approach to trading that goes beyond just AMMs or order books.

### What Makes CoW Swap Different? The "Coincidence of Wants" (CoW) and Batch Auctions

CoW Swap introduces the concept of a "Coincidence of Wants" (CoW). Imagine two people in a room: one wants to trade their apples for oranges, and the other wants to trade their oranges for apples. CoW Swap is the person who points them to each other, allowing them to trade directly, peer-to-peer, without needing to go through a "middleman" like a liquidity pool. This is incredibly efficient!

This direct matching happens within batch auctions. Or as we now call them, [Fair Combinatorial Batch Auctions](https://cow.fi/learn/cow-dao-launches-fair-combinatorial-batch-auctions-for-enhanced-trading). Here's how they work: user orders are collected into "batches" over a short period. Then, professional "solvers" (think of them as highly optimized trading bots) compete to find the most efficient way to settle all the orders within that batch. In our updated version of batch auctions, solvers can now fill part of the batch too.

This includes finding as many CoWs as possible and routing any remaining orders through the best available on-chain liquidity (from various AMMs and order books). The solver (or collection of solvers) who can provide the best overall price for everyone in the batch wins the right to execute the trades.

### Why CoW Swap is different

-   **MEV Protection (Maximal Extractable Value):** This is a huge advantage. On other DEXs, "front-running" or "sandwich attacks" (where malicious actors insert their own transactions before and after yours to profit at your expense) are a major problem. CoW Swap's batch auctions and solver competition drastically reduce [MEV](https://cow.fi/learn/a-guide-to-mev-on-ethereum-explained-cow-dao?ref=learn_search), acting like a shield that protects your trades from these predatory tactics.
    
-   **Gas Efficiency (Paid in Sell Token):** Ever been frustrated because you're out of ETH for gas fees just when you want to make a trade? [CoW Swap](https://swap.cow.fi/?utm_source=cow.fi&utm_medium=web&utm_content=menubar-nav-button-trade-on-cow-swap#/1/swap/USDC/COW) solves this! Gas fees are paid from the token you are selling, meaning you don't need to hold native chain tokens (like ETH on Ethereum) just for gas. This is a massive improvement for user experience.
    
-   **Optimal Pricing (Surplus for Traders):** Because solvers are highly incentivized to find the most efficient execution paths – leveraging both direct CoWs and the best on-chain liquidity – you often receive a better price than you'd expect. [CoW Swap](https://swap.cow.fi/?utm_source=cow.fi&utm_medium=web&utm_content=menubar-nav-button-trade-on-cow-swap#/1/swap/USDC/COW) actively finds surplus for you, putting more crypto in your pocket.
    
-   **Advanced Order Types:** [CoW Swap](https://swap.cow.fi/?utm_source=cow.fi&utm_medium=web&utm_content=menubar-nav-button-trade-on-cow-swap#/1/swap/USDC/COW) offers powerful features like gasless limit orders and [TWAP (Time-Weighted Average Price) orders](https://cow.fi/learn/cow-swap-launches-twap-orders?ref=learn_search). These give you much more control over your trades, allowing you to set specific price targets or spread a large order out over time – features rarely seen on other DEXs.
    
-   **Resilience and Robustness:** The decentralized solver competition adds a layer of security and ensures efficient trade execution, even in volatile market conditions.
    

### Choosing Your Champion DEX: What to Consider

Now that you understand the different types, how do you pick the best DEX for your needs?

-   **Your Trading Style:** Are you making frequent, small swaps? An AMM might be sufficient. Are you making large, price-sensitive trades? Consider aggregators or, even better, [CoW Swap](https://swap.cow.fi/?utm_source=cow.fi&utm_medium=web&utm_content=menubar-nav-button-trade-on-cow-swap#/1/swap/USDC/COW) for its MEV protection and optimal pricing. If you need advanced control with limit or TWAP orders, CoW Swap is a top contender.
    
-   **Gas Fees and Network:** Are you trading on a high-fee network like Ethereum mainnet, or a more affordable Layer 2? Does the DEX offer gas payment in the sell token, like CoW Swap, to save you from needing native chain tokens?
    
-   **Liquidity and Slippage:** For less common tokens, aggregators and CoW Swap can be invaluable for finding the best prices and minimizing slippage.
    
-   **User Experience (UX):** How intuitive is the interface for you? Do you prefer simpler swaps, or are you looking for more advanced features?
    
-   **Security:** Always stick to reputable DEXs and understand the risks involved, such as impermanent loss for liquidity providers on AMMs.
    

### Conclusion: Swap Smart

It's clear that not all DEXs are created equal. Understanding their underlying mechanics and unique features empowers you to make smarter trading decisions. Whether you're making a quick swap or executing a complex strategy, knowing the landscape can save you money and protect your assets.

While AMMs and aggregators serve valuable purposes, platforms like [CoW Swap](https://swap.cow.fi/?utm_source=cow.fi&utm_medium=web&utm_content=menubar-nav-button-trade-on-cow-swap#/1/swap/USDC/COW) represent the next evolution in decentralized trading. By prioritizing user protection through MEV resistance, offering gasless trading, and optimizing for the best prices, it truly stands out as a unique and powerful tool in the DeFi ecosystem.

So, go forth and explore! Try out different DEXs, understand their strengths, and find the one that helps you swap smarter and navigate the exciting world of DeFi with confidence. What's your favorite DEX, and why?

## Read more 📚

-   [Navigating DeFi Security Risks and Rewards for the Savvy User](https://cow.fi/learn/navigating-de-fi-security-risks-and-rewards-for-the-savvy-user)
    
-   [The Foundations of Decentralized Finance: A Comprehensive Guide to the DeFi Ecosystem](https://cow.fi/learn/the-foundations-of-decentralized-finance-a-comprehensive-guide-to-the-de-fi-ecosystem)
    
-   [Understanding DeFi Lending](https://cow.fi/learn/understanding-defi-lending)
    
-   [How to DYOR](https://cow.fi/learn/how-to-dyor)

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DEXes aren't all equal! Learn about AMMs, Order Books, & Aggregators. Discover CoW Swap's unique MEV protection & gasless trades for optimal, secure DeFi swaps. 

Finding the Right DEX for You: Why DEXes Aren’t All Built the Same


The world of finance is undergoing a silent, yet profound revolution. For centuries, money has flowed through a system built on centralized institutions - banks, brokers, and exchanges acting as trusted intermediaries. But a new paradigm is emerging: decentralized finance, or DeFi. Here, the traditional gatekeepers are replaced by code, transparency, and a network of interconnected protocols that enable anyone, anywhere, to participate in financial services without permission.

This article delves into the fundamental mechanisms and protocols that govern how money moves within the DeFi ecosystem. We will explore how value is created, transferred, and optimized, revealing the intricate dance of digital assets that underpins this rapidly evolving financial frontier. By unpacking these flows, we aim to provide a comprehensive understanding of the innovative potential and ongoing evolution of decentralized finance.

And if you’ve missed it, this is part of a [broader series on getting to grips with DeFi](https://cow.fi/learn/getting-started-with-de-fi-your-comprehensive-guide-to-decentralized-finance), breaks down the key ideas and technologies behind DeFi. From smart contracts that automate complex agreements to innovations like CoW Protocol that protect users from the hidden costs of trading - we'll look at what's being built, how it works, and why it matters.

### The Foundation: Building Blocks of DeFi Money Flow

At its core, DeFi relies on a few fundamental innovations that enable the permissionless movement of value.

#### Tokenization: The Digital DNA of Money

The lifeblood of DeFi is the token. In essence, tokens are digital representations of assets, rights, or even services, built on a blockchain. Unlike traditional currencies or assets that are tied to a physical form or centralized ledger, tokens are programmable and can represent almost anything.

Most DeFi applications utilize fungible tokens, primarily those adhering to standards like Ethereum's ERC-20. This standard ensures that tokens are interchangeable and can be easily integrated across various platforms. Examples include:

-   **Stablecoins:** Crucially important for DeFi, stablecoins like USDT, USDC, and USDS are designed to maintain a stable value, often pegged to a fiat currency like the US dollar. They act as a vital bridge between the volatile cryptocurrency market and the stability of traditional money, facilitating smoother transactions and reducing risk.
    
-   **Wrapped Assets:** To enable assets from one blockchain to operate on another (e.g., Bitcoin on Ethereum), "wrapped" versions are created (e.g., Wrapped Bitcoin or wBTC). These are tokens backed 1:1 by the underlying asset, allowing its value to flow across different blockchain ecosystems.
    

These tokens are the foundational units of value, freely circulating and interacting within the decentralized network, unlike the siloed accounts of traditional banking.

#### Blockchain as the Ledger

The underlying technology enabling this tokenized universe is the blockchain. A blockchain is a distributed, immutable ledger that securely records all transactions across a network of computers. Every transaction, once confirmed, is added to a block, which is then cryptographically linked to the previous one, forming a chain. This ensures transparency and prevents tampering, as all participants can verify the integrity of the ledger.

Crucially, smart contracts run on these blockchains. These are self-executing agreements with the terms of the agreement directly written into code. They automate financial agreements, removing the need for intermediaries and ensuring that money flows precisely as programmed. The cost of executing these smart contracts and transactions is typically paid in "gas fees," which compensate the network validators for their computational efforts. These fees, along with network congestion, can significantly impact the speed and cost of money moving through DeFi.

### Core Mechanisms of Money Flow in DeFi

With the foundational elements in place, let's explore the primary ways money moves and generates value within DeFi.

#### Exchange and Liquidity: The Marketplaces of DeFi

In traditional finance, stock exchanges and currency markets facilitate trading through order books, matching buyers and sellers. DeFi introduces a revolutionary approach: Decentralized Exchanges (DEXs).

Unlike centralized exchanges (CEXs) like Binance or Coinbase, DEXs (**[Like Cow Swap](https://swap.cow.fi/#/1/swap/WETH/0xA0b86991c6218b36c1d19D4a2e9Eb0cE3606eB48)**) operate without a central authority holding user funds. Instead, they leverage Automated Market Makers (AMMs). AMMs utilize smart contracts and liquidity pools to facilitate token swaps.

-   **How AMMs Work:** Instead of an order book, users trade against a pool of assets provided by other users called liquidity providers (LPs). The price of assets within the pool is determined algorithmically, often by a simple formula like x∗y=k (where x and y are the quantities of two tokens in a pool, and k is a constant). When a user swaps tokens, the relative quantities in the pool change, which in turn adjusts the price for subsequent trades.
    
-   **Role of Liquidity Providers (LPs):** LPs deposit equal values of two or more tokens into a liquidity pool. In return, they receive LP tokens, representing their share of the pool. They earn a portion of the trading fees generated by the pool, effectively getting paid for enabling others to trade.
    
-   **Impermanent Loss:** A key concept for LPs is "Impermanent Loss." This occurs when the price of the assets in a liquidity pool changes from the time they were deposited. If the price divergence is significant, the value of the LP's share might be less than if they had simply held the assets outside the pool. It's "impermanent" because it can reverse if prices return to their original ratios.
    

**How money flows here:** Users deposit their tokens into liquidity pools to earn fees, enabling other users to instantly swap between different cryptocurrencies without a centralized intermediary. Arbitrageurs also play a role, rebalancing pools by buying low and selling high across different DEXs or CEXs, helping to keep prices consistent. Examples include Uniswap, PancakeSwap, and Curve, and CoW Swap. 

#### Lending and Borrowing: Decentralized Credit Markets

DeFi has recreated the credit market, allowing users to lend out their crypto assets to earn interest or borrow against their holdings. These protocols operate without credit checks, relying instead on collateral.

-   **Overcollateralized Lending:** This is the most common form of lending in DeFi. Borrowers must deposit more collateral than the value of the loan they receive (e.g., depositing $150 worth of Ether to borrow $100 worth of stablecoins). This overcollateralization protects lenders from volatility.
    

-   **Interest Rate Models:** Interest rates are typically determined algorithmically based on supply and demand within the protocol's liquidity pools. As demand for borrowing increases, interest rates rise, incentivizing more lenders to deposit.
    
-   **Liquidation Mechanisms:** If the value of the collateral falls below a certain threshold relative to the loan (due to market price fluctuations), the collateral is automatically liquidated (sold) to repay the loan and cover any fees, protecting the lender.
    

-   **Flash Loans:** A unique DeFi innovation, flash loans are uncollateralized loans that must be borrowed and repaid within the same blockchain transaction. They are typically used by developers and arbitrageurs to execute complex strategies that require significant upfront capital without tying up personal funds. For example, a flash loan could be used to buy an asset cheaply on one DEX and sell it instantly for a higher price on another, repaying the loan immediately from the profits.
    

**How money flows here:** Lenders deposit their crypto assets into lending pools to earn passive income (interest). Borrowers pay interest to access capital for various purposes, often without selling their underlying assets. Liquidators profit from executing liquidations when collateral thresholds are breached. Prominent protocols include Aave and Compound, while SKY (formerly MakerDAO) allows users to mint DAI/USDS stablecoins by collateralizing other cryptocurrencies.

#### Yield Farming and Staking: Maximizing Returns

Beyond simple trading and lending, DeFi offers advanced strategies for users to maximize returns on their crypto assets, often referred to as "yield farming" and "staking."

-   **Yield Farming:** This involves strategically moving crypto assets across various DeFi protocols to generate the highest possible returns. It can include:
    

-   **Liquidity Mining:** Providing liquidity to DEXs or lending protocols in exchange for not just trading fees or interest, but also additional governance tokens issued by the protocol itself. These tokens often grant voting rights in the protocol's future direction and can also be traded on secondary markets, creating additional yield.
    
-   **Compounding Yields:** Reinvesting earned rewards back into the protocols to generate even more returns.
    

-   **Staking:** In Proof-of-Stake (PoS) blockchains, users can "stake" their tokens to help secure the network and validate transactions. In return, they earn new tokens as rewards. Liquid staking solutions (e.g., Lido Finance) allow users to stake their tokens while still retaining a liquid, tradable representation of their staked assets, unlocking further DeFi opportunities.
    

**How money flows here:** Users actively allocate and reallocate their capital across various protocols to chase the highest returns, effectively directing liquidity to where incentives are strongest. Protocols distribute new tokens or a share of their revenue to incentivize participation and grow their ecosystems.

#### Stablecoins: The Pillars of Stability

As mentioned, stablecoins are indispensable for the efficient flow of money in DeFi. Given the inherent volatility of most cryptocurrencies, stablecoins provide a crucial anchor, enabling:

-   **Reduced Risk:** Users can convert volatile assets into stablecoins to protect their value during market downturns.
    
-   **Easier Transactions:** Stablecoins facilitate smoother and more predictable transactions for payments, lending, and other financial activities within DeFi.
    
-   **Liquidity:** They provide deep liquidity for trading pairs and serve as reliable collateral.
    

How money flows here: Users swap volatile cryptocurrencies for stablecoins to manage risk or for everyday transactions. They are widely used as the primary collateral for loans, the base currency in liquidity pools, and for peer-to-peer transfers, providing a stable medium of exchange within a dynamic ecosystem.

### Interoperability and Cross-Chain Flows

The DeFi ecosystem is not monolithic; it spans multiple independent blockchain networks (e.g., Ethereum, Solana, Polygon, Avalanche). While each chain offers unique advantages, this creates a challenge: how do assets and value flow between them?

-   **The Challenge of Siloed Blockchains:** Each blockchain operates independently, making direct asset transfers complex.
    
-   **Bridging Solutions:**  Blockchain bridges are protocols that enable the transfer of assets and data between different chains. They often work by "locking" assets on one chain and "minting" an equivalent wrapped version on the destination chain. For instance, you could bridge ETH from Ethereum to Polygon to access lower transaction fees. While essential, bridges have been a target for exploits due to their complex smart contracts, representing a significant security risk.
    
-   **Layer 2 Solutions:** These are scaling solutions built on top of a main blockchain (like Ethereum) to process transactions more efficiently and at lower cost. Money flows onto Layer 2s (e.g., Arbitrum, Optimism, zkSync, Polygon) to benefit from faster and cheaper transactions, and then can be "bridged" back to the mainnet.
    

**How money flows here:** Users actively move their assets across different chains and Layer 2s to exploit arbitrage opportunities, access specific DApps, or simply to reduce transaction costs, contributing to a truly interconnected financial web.

### The Role of Oracles and Governance

Beyond the direct movement of funds, two other elements are crucial for the integrity and evolution of DeFi money flows.

-   **Oracles:** Smart contracts are deterministic and cannot access external, real-world data directly. Oracles are third-party services that feed external information (like real-time asset prices, interest rates, or election results) onto the blockchain in a secure and verifiable way. Without reliable oracle feeds, lending protocols couldn't accurately determine liquidation thresholds, and AMMs wouldn't have precise pricing data. Chainlink is the most prominent oracle network.
    
-   **Decentralized Autonomous Organizations (DAOs) and Governance:** Many DeFi protocols are governed by DAOs (like CoW DAO!), where token holders have voting rights proportionate to their holdings. This allows the community to collectively decide on crucial parameters that affect money flows, such as fee structures, interest rate models, token emissions for yield farming, and even upgrades to the protocol's smart contracts. This represents a flow of decision-making power from centralized entities to the community. Find out more about how [CoW DAO works here.](https://docs.cow.fi/governance?utm_source=cow.fi&utm_medium=web&utm_content=menubar-nav-button-governance)
    

### Risks and Challenges in DeFi Money Flows

While innovative, the free flow of money in DeFi is not without risks:

-   **Smart Contract Risks:** Bugs or vulnerabilities in the underlying code can lead to significant financial losses or "rug pulls" where developers drain liquidity.
    
-   **Impermanent Loss:** As discussed, LPs face the risk of their pooled assets losing value relative to simply holding them.
    
-   **Liquidation Risk:** Borrowers risk their collateral being sold off if asset prices drop significantly.
    
-   **Rug Pulls and Scams:** The permissionless nature of DeFi means anyone can launch a protocol, leading to a proliferation of fraudulent projects designed to steal user funds. Due diligence is paramount.
    
-   **Regulatory Uncertainty:** The evolving regulatory landscape poses risks, as new rules could impact how money can flow into and out of DeFi.
    

### Conclusion

The way money flows in DeFi represents a fundamental departure from the traditional financial system. It's a dynamic, interconnected network where value is constantly being created, exchanged, lent, borrowed, and optimized through autonomous smart contracts and transparent blockchain ledgers. From the foundational role of tokenization and the innovative mechanics of AMMs and lending protocols, to the intricate strategies of yield farming and the crucial function of stablecoins, DeFi is building a truly open and permissionless financial ecosystem.

While challenges and risks persist, the ongoing evolution of bridging solutions, Layer 2 scaling, and robust oracle networks continues to enhance the efficiency and accessibility of these flows. As the world becomes increasingly digital, understanding how money flows in DeFi is not just about comprehending a niche financial trend; it's about grasping the blueprint for a potential future of finance - one where control is decentralized, access is universal, and innovation is limitless.

One of the missions of CoW DAO is make DeFi a safe, secure, and simple place to navigate. So if you want to trade in a trustless environment, use **[Cow Swap](https://swap.cow.fi/#/1/swap/WETH/0xA0b86991c6218b36c1d19D4a2e9Eb0cE3606eB48)!** 

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Discover how money flows in DeFi. Explore tokens, DEXs, lending, yield farming, and stablecoins. Understand the core mechanisms of decentralized finance, from liquidity pools to smart contracts, shaping the future of money.

How Money Flows in DeFi: Unpacking the Decentralized Financial System


Building a sound long-term investment thesis requires understanding both the technology and its practical applications. The crypto space is filled with impressive-sounding innovations, but not all technological advances translate into valuable or necessary products.

  

Research helps investors distinguish between temporary hype cycles that will eventually fade and genuine long-term potential that could drive sustainable growth. This distinction becomes particularly valuable during market downturns, as conviction built through thorough research helps investors maintain positions when weaker hands are selling in panic.

  

Do Your Own Research (DYOR) emphasizes the importance of individual investigation before committing capital. In a space where information asymmetry is common and traditional financial gatekeepers are absent, DYOR represents both self-protection and community responsibility.

  

This article outlines the systematic approaches investors can take to evaluate crypto projects, covering everything from technical assessment and team evaluation to tokenomics analysis and community engagement.

And if you’ve missed it, this is part of a [broader series on getting to grips with DeFi](https://cow.fi/learn/getting-started-with-de-fi-your-comprehensive-guide-to-decentralized-finance), breaks down the key ideas and technologies behind DeFi. From smart contracts that automate complex agreements to innovations like CoW Protocol that protect users from the hidden costs of trading - we'll look at what's being built, how it works, and why it matters.

## Define Your Research Goals

Long-term investors need to focus on fundamentals like technology innovation, team capabilities, and market fit, while traders might prioritize technical patterns, market sentiment, and upcoming catalysts.

  

When examining a project's technology, determine whether you're evaluating its innovation relative to existing solutions or its practical utility for solving real-world problems. Many crypto projects feature impressive technical specifications but address problems that don't genuinely require blockchain solutions.

  

The focus of your tokenomics analysis should also be clearly defined. Are you primarily concerned with token distribution, utility within the ecosystem, value capture mechanisms, or governance rights? Each of these aspects requires different analytical frameworks. By establishing clear objectives before beginning your research, you can better prioritize information and avoid becoming overwhelmed by the vast amount of data available for each project.

## Analyze the Fundamentals

### Team Assessment

The people behind a cryptocurrency project often determine its success or failure more than any other factor – though it’s also normal for teams to remain anonymous. If possible, try to uncover any available details about the history of the creators behind a project – for example, by tracking the history of their pseudonymous personas across channels like Discord, GitHub, and others.

### Tokenomics

The economic model of a cryptocurrency can make or break its long-term viability, regardless of the underlying technology. Review the token distribution model and allocation percentages to understand who holds the power in the ecosystem. Projects that heavily favor team members, insiders, and venture capitalists may be designed primarily to enrich early participants rather than build sustainable value for all token holders.

  

Examine vesting schedules for team and investor tokens to assess potential selling pressure. Short or non-existent lockup periods can lead to dramatic price declines when insiders are able to sell their holdings. Understanding the token's utility and how it captures value is critical—does the token have a genuine reason to exist within the ecosystem, or is it an unnecessary addition to an otherwise functional system?

  

Analyze total supply, circulating supply, and inflation/deflation mechanisms to gauge how token value might evolve over time. High inflation rates can significantly dilute holder value, while well-designed deflation can create sustainable price appreciation if demand remains steady.

### Problem and Solution

Every legitimate cryptocurrency project should clearly identify the specific problem it aims to solve.

  

Evaluate whether this problem is significant enough to warrant a solution and whether blockchain technology is truly necessary to address it. Many projects force blockchain integration into problems that could be more efficiently solved with traditional technologies.

  

Consider if the project's approach is novel or simply repackaging existing solutions with minimal improvements. True innovation creates competitive advantages that can sustain value over time. Assess the size of the potential market and realistic adoption barriers—even excellent solutions face challenges in gaining traction, particularly when competing against established alternatives or requiring significant changes in user behavior. If in doubt, ask the projects themselves for this information. Join Discord / Telegram channels and ask questions. Good teams should be willing to share this information. Bad teams won't.

## Technical Evaluation

### Codebase Analysis

A project's GitHub repository often reveals more truth than its marketing materials. Active development with regular contributions suggests a committed team working to improve the product, while infrequent updates or abandoned repositories serve as major red flags.

  

When examining a project's codebase, check whether it's open-source and properly documented. Closed-source projects ask investors to trust the developers' claims about functionality without verification, significantly increasing risk. Well-documented code indicates professionalism and consideration for other developers who might contribute to the project.

  

Security audits by reputable firms provide an additional layer of verification.

  

Look for comprehensive audits from established companies like CertiK, Hacken, or PeckShield rather than superficial reviews from unknown entities. Multiple audits from different firms offer stronger security assurance than a single review. Pay attention to how the development team responds to reported issues – transparent acknowledgment and quick fixes demonstrate responsibility, while dismissive attitudes or slow responses suggest potential governance problems.

### Technical Roadmap

A well-designed roadmap provides insight into a project's future direction and the team's ability to set realistic goals. Review the development roadmap and compare it against past milestone achievements to gauge whether the team consistently delivers on promises. Projects with a history of missed deadlines or scaled-back features often continue this pattern.

## Community and Ecosystem Evaluation

A project's community often reflects its long-term prospects more accurately than its price chart. Vibrant, engaged communities typically sustain projects through market downturns, while inactive or toxic communities frequently correlate with abandoned development and eventual failure.

  

When evaluating a project's community, gauge engagement levels across platforms like Reddit, Discord, Telegram, and Twitter.

  

The substance of community discussions provides particularly valuable insights. High-quality communities feature technical discussions, constructive criticism, and problem-solving conversations between users and team members.

### Developer Ecosystem

For platforms and protocols aiming to support third-party development, the health of their developer ecosystem serves as a critical indicator of future success.

  

Research the number of active developers building on the platform, as larger and growing developer communities create network effects that can drive long-term adoption.

  

Don't just accept the project's claims about developer interest—look for tangible evidence like GitHub activity, hackathon participation, and independent applications being built on the platform.

## Documentation and Review

Systematic documentation of your research findings creates valuable reference material for future decisions and helps identify patterns in your analytical process. Creating a structured template for evaluating different projects enforces consistency and reduces the influence of changing market sentiment on your assessments.

  

Effective templates include sections for team analysis, technology evaluation, tokenomics, competitive positioning, and risk factors, with consistent rating systems to facilitate comparisons across different investments.

  

When documenting your findings, make a deliberate effort to note both positive aspects and concerns for balanced assessment. The strongest research acknowledges limitations and risks even in promising projects rather than presenting one-sided evaluations. This balance helps counter confirmation bias and creates more reliable decision-making frameworks.

  

Dating your research creates a valuable historical record that demonstrates how your understanding evolves alongside market developments. Revisiting previous research when significant developments occur helps identify which aspects of your analysis proved accurate and which missed important factors. This iterative process strengthens your research skills over time and helps identify personal analytical blindspots.

  

Perhaps most importantly, compare your findings against your initial investment thesis to ensure alignment between research and action. Research that contradicts your initial thesis should prompt reconsideration of positions rather than selective interpretation to support existing views. The discipline to adjust positions based on evidence rather than emotions distinguishes successful long-term investors from those who fall victim to behavioral biases and market cycles.

## Market Analysis Tools

Comprehensive market data is the foundation of any solid research strategy. Data aggregators provide essential price information, market capitalization rankings, and trading volumes across hundreds of exchanges:

  

-   [CoinGecko](https://www.coingecko.com/) - Tracks 12,000+ cryptocurrencies with detailed market data
    
-   [CoinMarketCap](https://coinmarketcap.com/) - Industry standard for market capitalization rankings
    
-   [Messari](https://messari.io/) - Institutional-grade research and market intelligence
    

  

Technical analysis is crucial for identifying potential entry and exit points. Advanced charting platforms like [TradingView](https://www.tradingview.com/) offer customizable indicators and pattern recognition tools that can help visualize market trends. For traders looking to gauge market sentiment, the [Crypto Fear & Greed Index](https://alternative.me/crypto/fear-and-greed-index/) provides a simple metric to understand when the market might be overheated or undervalued.

  

Specialized market screeners have emerged as powerful tools for identifying trading opportunities:

  

-   [DYOR.net](https://dyor.net/) - Crypto screener that analyzes trend patterns every 15 minutes
    
-   [CryptoQuant](https://cryptoquant.com/) - Focuses on exchange flows and whale movements
    
-   [LunarCrush](https://lunarcrush.com/) - Correlates social activity with price movements
    

### Blockchain Intelligence

On-chain analysis has revolutionized cryptocurrency research by providing unprecedented transparency into blockchain activity. Several platforms now offer sophisticated metrics that go far beyond basic transaction data:

  

Glassnode stands out for its advanced on-chain metrics and intelligence for Bitcoin and Ethereum. The platform's [insights](https://glassnode.com/) into network value, holder behavior, and market cycles have become essential for serious investors developing long-term theses.

  

Blockchain explorers provide windows into transaction activity and serve as vital verification tools:

  

-   [Etherscan](https://etherscan.io/) - The gold standard for Ethereum blockchain exploration
    
-   [BscScan](https://bscscan.com/) - Essential tool for Binance Smart Chain research
    
-   [Solscan](https://solscan.io/) - Comprehensive Solana blockchain explorer
    
-   [Snowtrace](https://snowtrace.io/) - Detailed analytics for Avalanche network
    

  

The DeFi landscape requires specialized tools to track the complex interrelationships between protocols:

  

-   [DefiLlama](https://defillama.com/) monitors Total Value Locked (TVL) across 800+ DeFi protocols and 80+ blockchains, providing crucial insights into liquidity trends.
    
-   For project-specific metrics, [Token Terminal](https://tokenterminal.com/) offers financial data that treats crypto protocols like traditional companies, making fundamental analysis more accessible even for those with traditional finance backgrounds.
    

### Security and Risk Assessment

  

-   CertiK ([www.certik.com](http://www.certik.com)) maintains the most comprehensive security leaderboard of audited projects, scoring them based on multiple risk factors beyond just code quality. Their assessments include governance risks, centralization concerns, and historical security incidents to provide a more holistic view of potential vulnerabilities.
    
-   For investors seeking additional verification, Hacken (hacken.io) offers thorough blockchain security assessments that often catch issues other auditors miss, while PeckShield (peckshield.com) specializes in security intelligence that tracks emerging threats across the ecosystem in real-time.
    

### Project Evaluation Resources

The github repository of a project reveals far more about its health and potential than most marketing materials. Active development signals ongoing improvement and adaptation, while abandoned repositories often indicate projects that exist primarily for speculation rather than genuine utility.

  

-   CryptoMiso ([www.cryptomiso.com](http://www.cryptomiso.com)) ranks cryptocurrencies based on their GitHub commit history, providing an accessible overview of which projects maintain active development.
    
-   For more nuanced analysis, Santiment's Development Activity metric (app.santiment.net/dashboards/development-activity) filters out non-development activities like documentation updates to focus specifically on code-related changes, offering a clearer picture of actual technical progress.
    

  

Tokenomics analysis requires examining distribution patterns and vesting schedules that could impact future price action.

  

-   Token Unlocks (token.unlocks.app) has become the standard tool for monitoring vesting schedules and upcoming unlock events that might increase selling pressure on a token's price.
    
-   For those concerned about concentration risk, Nansen ([www.nansen.ai](http://www.nansen.ai)) offers wallet profiling and token holder behavior analysis that can reveal whether a seemingly decentralized project is actually controlled by a small number of addresses working in concert.
    

  

The governance mechanisms of a project reveal much about its true decentralization and decision-making processes. Well-designed governance empowers community members while preventing capture by wealthy token holders or insider groups.

  

-   Boardroom (boardroom.io) provides dashboards for monitoring governance activities across multiple protocols, showing proposal histories, voting patterns, and participation rates that help assess whether governance is functioning as intended.
    
-   For those looking to participate in governance directly, Tally ([www.tally.xyz](http://www.tally.xyz)) offers user-friendly interfaces for creating and voting on proposals, making governance more accessible to average users rather than just large stakeholders and technical experts.
    

### Portfolio and Research Management

Keeping track of investments across multiple chains and protocols has become increasingly complex. Modern portfolio tools help simplify this process:

  

-   [CoinStats](https://coinstats.app/) integrates with 70+ wallets and 400+ exchanges to provide comprehensive portfolio tracking
    
-   [Zapper](https://zapper.fi/) specializes in DeFi positions across multiple chains.
    
-   For those interested in following expert investors, [Arkham Intelligence](https://www.arkhamintelligence.com/) offers tools to track whale wallets and institutional movements.
    

  

Research publications provide professional analysis that can supplement your own findings:

  

-   [Messari Research](https://messari.io/research) - In-depth reports on specific sectors
    
-   [The Block Research](https://www.theblock.co/research) - Market intelligence and analysis
    
-   [Delphi Digital](https://www.delphidigital.io/research) - Institutional-grade research reports
    

  

These publications often provide context and comparative analysis that would be difficult for individual researchers to compile, making them valuable additions to your DYOR process.

  

## Conclusion

Building a robust long-term investment thesis in the crypto space is an ongoing journey that demands discipline and a commitment to thorough research. By systematically evaluating a project's technology, team, tokenomics, and community engagement, investors can cut through the noise of fleeting trends and identify genuine potential.

The "Do Your Own Research" (DYOR) ethos empowers individuals to make informed decisions, navigate market volatility with conviction, and ultimately position themselves for sustainable growth. The tools and methodologies outlined in this article are not just theoretical frameworks; they are practical guides designed to transform speculative impulses into strategic investments, ensuring your participation in the crypto economy is both informed and resilient.

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Master long-term crypto investing with DYOR. Learn to assess tech, teams, tokenomics, and community. Distinguish hype from potential and build conviction for sustainable growth.

How to DYOR


Decentralized Finance (DeFi) is redefining how financial systems operate - and lending is one of its most powerful, and complex, tools. Whether you're looking to unlock liquidity, hedge your exposure, or execute more sophisticated strategies, understanding how DeFi lending works is essential.

  

This guide will walk through the fundamentals of DeFi lending: how it works, where the opportunities lie, and how to protect yourself. Whether you're just getting started or looking to sharpen your edge, we'll help you build a safer, smarter approach to on-chain lending.

## What is DeFi Lending?

At its core, DeFi lending allows users to borrow and lend digital assets via smart contracts, without the need for traditional intermediaries like banks. Instead of credit scores or paperwork, loans are issued based on collateral. Value is locked in, interest accrues, and everything is executed programmatically on-chain.

  

This isn't about mortgages or car loans. DeFi lending isn't built for consumer finance - it's built for capital efficiency. Traders use lending protocols to access liquidity without selling their assets, enabling strategies like collateral swaps, yield farming, and more complex forms of risk management.

  

Done well, DeFi lending unlocks flexibility and control over your portfolio. Done recklessly, it exposes you to liquidation risks, volatile interest rates, and smart contract vulnerabilities. This is a tool - not a shortcut - and it requires a clear understanding of both the mechanics and the risks involved.

## The Appeal of DeFi Lending: Speed and Scale

Lending and borrowing, fundamentally, are mechanisms for managing liquidity. Lending allows you to put your dormant assets to work, generating interest. Borrowing, conversely, enables you to secure liquidity by using existing assets as collateral.

DeFi lending operates on these same principles, but the inherent speed of blockchain transactions and smart contracts dramatically broadens the scope and efficiency of lending and borrowing techniques.

Hard-coded smart contracts provide a high degree of confidence for lenders, as the terms are immutable and self-executing. This intrinsic trust makes it significantly easier to access loans, provided you possess the necessary collateral. The instant execution of smart contracts ensures that funds are moved quickly and securely, making it ideal for rapid market movements and complex strategies.

## Example: DeFi Lending with ETH

Let's break it down with a concrete scenario.

Suppose you're holding 4 units of a token currently trading at 0.2 ETH each. You're bullish on its future and don't want to sell - but you've also got your eye on other opportunities and need liquidity now to cover transaction fees or initiate new trades.

This is where DeFi lending comes into play.

Rather than liquidating your position, you deposit 2 of your tokens as collateral into a lending protocol. Based on collateralisation ratios - which typically range between 50-75% depending on the protocol - you borrow 0.04 ETH.

That 0.04 ETH can now be deployed however you choose: swapping into another asset, covering gas fees, or stacking into another strategy. When your original token appreciates, you repay the loan (plus interest), reclaim your collateral, and retain exposure to the asset's upside.

If the token has gained more value than the cost of your loan, you've effectively extracted liquidity without sacrificing your position - a classic example of smart capital efficiency.

But this strategy cuts both ways. If the token's price drops significantly, your position could be partially or fully liquidated, especially if you fail to maintain the required collateral ratio. Repayment becomes more expensive, and the upside disappears. Risk management - not just market conviction - is essential.

Used well, DeFi lending allows you to work your assets harder. Used recklessly, it can unwind positions fast. Know the protocol. Understand the terms. And always size your positions with downside protection in mind.

## Flash Loans: Uncollateralized DeFi Lending

Flash loans are one of the most powerful - and misunderstood - instruments in decentralized finance. Unlike traditional lending, these loans don't require any collateral. Instead, they rely on the atomic nature of blockchain transactions: everything happens in a single block, or nothing happens at all.

Here's how it works: A smart contract executes a predefined series of steps - borrowing, swapping, repaying - all in one go. If any part of the chain fails, the entire transaction reverts. No harm, no foul. This structure makes flash loans incredibly secure for lenders, while offering users unprecedented liquidity for a few seconds of execution time.

Let's walk through an example.

### Example: Flash Loan Strategy on Sepolia

Say you've borrowed 10,000 USDT, backed by 500,000 USDC as collateral. You want to repay part of the debt and reclaim some of that locked USDC. Here's how a flash loan can make it work:

1.  **Initiate Flash Loan:** Borrow 5,000 USDT instantly via a flash loan.
    
2.  **Partial Repayment:** Use the borrowed USDT to pay back half of your original debt.
    
3.  **Unlock Collateral:** Based on the new loan balance, withdraw 400,000 USDC from your collateral.
    
4.  **Repay Flash Loan:** Swap the USDC for USDT (ensuring you net more than the 5,000 USDT plus fees), then repay the flash loan - all within one atomic transaction.
    

The result? You've reduced your debt, freed up a large chunk of your USDC, and repaid the flash loan - without ever risking your own capital upfront.

Flash loans are a game of precision. They enable advanced strategies like arbitrage, collateral swaps, and debt restructuring - but only if every step in the plan executes flawlessly. If not? The entire operation is cancelled before it even hits the blockchain.

It's automation with built-in safeguards.

For a step-by-step implementation tutorial, check out the [CoW Protocol Flash Loan docs](https://docs.cow.fi/cow-protocol/tutorials/cow-swap/flash-loans).

## MEV Risks in DeFi Lending

While powerful, DeFi lending, especially with techniques like flash loans, relies on specific sequences of orders and often precise price execution. This inherent ordering creates vulnerabilities to [Maximal Extractable Value (MEV)](https://cow.fi/learn/what-is-mev?ref=learn_search) attacks. MEV refers to the profit that can be extracted by reordering, inserting, or censoring transactions within a block.

MEV attackers can manipulate order sequences after a user's transaction is submitted but before it's confirmed on the blockchain. For instance, changing the price of a token involved in a flash loan or a complex lending strategy can breach the terms of the smart contract, leaving the borrower exposed even if their intended transactions were perfectly valid. This risk highlights the critical need for robust protection mechanisms in the DeFi lending space.

## How CoW DAO Protects Against MEV for DeFi Lending

In DeFi, the danger isn't always obvious. It's not just volatility or bad calls - it's hidden threats like MEV ([Maximal Extractable Value](https://cow.fi/learn/is-mev-good-or-bad?ref=learn_search)), where bots frontrun, sandwich, or manipulate your trades before they ever settle.

CoW has built an ecosystem to stop that - at the infrastructure layer, the user layer, and everywhere in between.

## CoW Protocol: Infrastructure Built to Defend

At the core is [CoW Protocol](https://cow.fi/cow-protocol) - the intent-based infrastructure that flips the traditional mempool model on its head. Instead of broadcasting raw transactions where anyone can exploit them, users submit intents to trade.

A network of independent solvers competes to find the most efficient way to settle those intents - often batching multiple trades together, matching orders peer-to-peer, or sourcing liquidity across multiple venues. Because solvers earn by optimizing for the user - not extracting from them - malicious MEV becomes obsolete.

This is infrastructure that puts the user first, by design.

## CoW Swap: MEV-Protected Trading, Out of the Box

[CoW Swap](https://swap.cow.fi/#/1/swap/WETH/0xA0b86991c6218b36c1d19D4a2e9Eb0cE3606eB48) is our meta DEX - the most accessible way to tap into the power of CoW Protocol.

You get:

-   Best-execution routing across DEXs
    
-   Zero gas fees (via meta-transactions)
    
-   Built-in protection from MEV and slippage
    
-   A seamless experience, even for complex trades
    

No need to manage approvals, gas settings, or worry about bots front-running your swaps. [CoW Swap](https://swap.cow.fi/#/1/swap/WETH/0xA0b86991c6218b36c1d19D4a2e9Eb0cE3606eB48) brings solver-powered protection to the front-end - so you don't have to think about it.

## MEV Blocker: Wallet-Level Defense, Everywhere You Go

Sometimes you're not using CoW Swap. You're out there farming, minting, LPing, or bridging across the DeFi universe. [MEV Blocker](https://cow.fi/mev-blocker) is built for those moments.

Just connect to the MEV Blocker RPC in your wallet, and it routes your transactions privately to trusted builders - keeping them off the public mempool and safe from MEV attacks.

MEV Blocker works anywhere you trade, giving you:

-   Protection from frontrunning, backrunning and sandwich attacks.
    
-   Zero disruption to your usual workflow.
    
-   The potential to earn rebates from searchers bidding to include your transaction.
    

This is plug-and-play protection, with zero trade-offs.

Whether you're executing a simple token swap or managing a complex liquidity strategy, MEV can silently eat into your margins. CoW DAO’s product stack gives you layered defense - at the infrastructure level (CoW Protocol), the user level (CoW Swap), and the wallet level (MEV Blocker).

It's not just about protection. It's about making DeFi fairer, more efficient, and actually usable - for everyone.

## Conclusion: Lending Smarter Starts with Trading Safer

  

DeFi lending opens powerful doors - from unlocking liquidity without selling your assets, to leveraging advanced tools like flash loans for strategic capital moves. But with that power comes risk, especially from MEV attacks that can silently erode your edge before your strategy even hits the chain.

  

That's why CoW is more than a trading platform - it's a protective layer for your entire DeFi stack:

-   **[CoW Protocol](https://cow.fi/cow-protocol)** ensures your transactions are settled efficiently and fairly through competitive solver execution.
    
-   **[CoW Swap](https://swap.cow.fi/#/1/swap/WETH/0xA0b86991c6218b36c1d19D4a2e9Eb0cE3606eB48)** gives you direct access to MEV-resistant, gasless trading - optimized across chains and DEXs.
    
-   **[MEV Blocker](https://cow.fi/mev-blocker)** embeds protection directly into your wallet, guarding your transactions wherever you go in DeFi.
    

  

In a space where every basis point counts, CoW helps you keep more of what's yours - and execute with confidence.

  

Stay protected. Trade smarter. [Try CoW Swap](https://swap.cow.fi/#/1/swap/WETH/0xA0b86991c6218b36c1d19D4a2e9Eb0cE3606eB48)

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DeFi lending offers new possibilities in liquidity management through smart contracts. Learn how to leverage these techniques safely with CoW DAO.

Understanding DeFi Lending

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DeFi puts power in your hands - and responsibility too. This guide breaks down the biggest risks, smartest habits, and essential tools to help you stay safe while navigating the fast-moving world of decentralized finance.

Navigating DeFi Security Risks and Rewards for the Savvy User

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This guide, part of our broader series on getting to grips with DeFi, breaks down the key ideas and technologies behind DeFi.

The Foundations of Decentralized Finance: A Comprehensive Guide to the DeFi Ecosystem

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If you're new to the space or looking to deepen your understanding, this guide offers a comprehensive, beginner-friendly roadmap to navigating DeFi confidently.

Getting Started with DeFi: Your Comprehensive Guide to Decentralized Finance

![AMM (1).png](https://celebrated-gift-f83e5c9419.media.strapiapp.com/AMM_1_75dbb6998d.png)
The cryptocurrency space can often feel overwhelming, especially when you're just starting out. Between technical jargon, rapidly evolving technology, and a firehose of new platforms and tools, it's hard to know where to begin. One of the foundational innovations of decentralized finance (DeFi) that's worth understanding early on is the Automated Market Maker, or AMM.

In this guide, we'll break down what AMMs are, how they differ from traditional market makers, and how innovations like  [CoW AMM](https://cow.fi/cow-amm)  are taking this technology even further - making decentralized trading more secure, efficient, and fair.

## What Is an Automated Market Maker?

Let's start with the basics.

In traditional finance, when you want to buy or sell a stock, your trade is matched through an order book - a system that pairs buyers and sellers. This system usually requires market makers - typically large institutions or traders - who provide liquidity by offering to buy and sell assets at certain prices. Their job is to ensure smooth trading and reduce volatility.

In contrast, Automated Market Makers (AMMs) are a decentralized alternative. Instead of relying on human market makers or order books, AMMs use smart contracts (self-executing code on a blockchain) to enable peer-to-peer trading.

### Enter Liquidity Pools

Here's how it works in simple terms:

AMMs rely on liquidity pools - essentially shared pots of tokens. These pools are filled by users called liquidity providers (LPs) who deposit two tokens into the pool in equal value. For example, a common trading pair might be ETH/USDC, where someone deposits an equal dollar amount of Ethereum (ETH) and the stablecoin USDC.

These deposited tokens then become available for others to trade against. Rather than matching with another individual trader, users trade against the pool itself, and a mathematical formula adjusts the price based on the ratio of the two tokens.

### Example: The Constant Product Formula

Most AMMs, like those used in Uniswap, use a formula that looks like this:

x * y = k

Where:

-   x = amount of Token A
    
-   y = amount of Token B
    
-   k = constant (remains unchanged)
    

If someone wants to buy Token A, they must add Token B to the pool. This shifts the balance, increasing the price of Token A slightly, creating the supply-and-demand curve that you'd expect in any market.

This method ensures there's always a price and always liquidity - even if no one else is around to trade.

There are other types of pool that use different formulas to create what are called weighted pools, but in this example we're going to stick with the most common type of AMM.

## Why Are AMMs a Big Deal?

AMMs are at the heart of DeFi because they remove the need for intermediaries. Here's why they're a major innovation:

### 1. They're Always Open

Unlike centralized exchanges, which might have downtime or rely on limited liquidity during off hours, AMMs are available 24/7. As long as there's liquidity in the pool, you can trade.

### 2. Anyone Can Provide Liquidity

In traditional finance, only big players act as market makers. In AMMs, anyone with crypto can contribute to a liquidity pool and earn fees from trades - democratizing access.

### 3. They're Non-Custodial

You never give up control of your assets to a centralized platform. Everything happens on-chain, and your wallet always holds your funds until you actively interact with a smart contract.

## The Downsides of AMMs

AMMs aren't perfect. As with any tool, there are trade-offs:

### Impermanent Loss

If you provide liquidity to a pool and the price of one token changes significantly compared to the other, you might end up with less money than if you'd simply held onto your tokens. This phenomenon is called impermanent loss.

### MEV (Maximal Extractable Value)

Here's where things get a bit tricky: On public blockchains, anyone can see pending transactions. Some sophisticated bots and traders use this visibility to front-run trades - they jump ahead in line and profit from the price movements that your trade causes.

This is part of a broader problem called  [Maximal Extractable Value](https://cow.fi/learn/a-guide-to-mev-on-ethereum-explained-cow-dao?ref=learn_search)(MEV) - where someone extracts value from a block by strategically ordering transactions. And unfortunately, regular users and liquidity providers often lose out in this process.

Find out more about  [MEV and how it works here.](https://cow.fi/learn/a-guide-to-mev-on-ethereum-explained-cow-dao?ref=learn_search)

### Loss Versus Rebalancing (LVR)

[LVR](https://cow.fi/learn/what-is-loss-versus-rebalancing-lvr?ref=learn_search)  is a form of arbitrage that occurs whenever an AMM has an outdated (stale) price in comparison to some other trading venue. Arbitrageurs exploit this difference by trading from the AMM to the more liquid exchange (usually a centralized exchange like Binance), correcting the arbitrage and extracting value from LPs in the process.

Find out more about  [LVR and how it works here](https://cow.fi/learn/what-is-loss-versus-rebalancing-lvr?ref=learn_search).

## Introducing CoW AMM: A New Kind of AMM

This is where  [CoW AMM](https://cow.fi/cow-amm)  comes in - a novel approach developed by  [CoW DAO](https://cow.fi/)  that addresses some of the most pressing issues facing current AMM models.

Let's explore how this system works and why it might represent the next evolution in decentralized trading.

What Makes CoW AMM Different?

### Protection from MEV

[CoW AMM](https://cow.fi/cow-amm)  tackles MEV head-on by using batch auctions and intent-based trading.

Rather than letting every trade hit the chain instantly (and visibly), CoW AMM allows multiple trade "intents" to be submitted off-chain. Then, these intents are matched and executed together in a single batch.

Because all trades are processed simultaneously, there's no opportunity for front-running - bots can't jump ahead and exploit your trade.

This process happens through a solvers network - specialized bots that compete to offer users the best execution. It's a win-win for both users and liquidity providers.

### Capital Efficiency & Enhanced Yield

Traditional AMMs spread liquidity across the entire possible price range. That means your tokens might sit unused if no trades happen near their price.

CoW AMM allows LPs to concentrate their liquidity into targeted price ranges - making better use of capital and increasing the chance that they'll earn trading fees.

It works similarly to how index funds concentrate around certain market segments. That's why a CoW AMM - once new features have been deployed - acts as an "enhanced index fund" for DeFi - your funds are passively managed, but smartly deployed for better returns.

## Real-Life Example: CoW AMM in Action

Let's say you want to swap 1 ETH for USDC using CoW AMM.

1.  You submit an "intent to trade" - a request that says, "I want to swap 1 ETH for the best possible amount of USDC."
    
2.  Your intent goes into a batch with many others.
    
3.  CoW Protocol's solver network analyzes the best path for execution - across multiple pools, DEXs, or even aggregators.
    
4.  The batch is executed, and you receive your USDC - with less slippage, no MEV, and often a better price than on a traditional AMM.
    

As a result, users trade with confidence, and LPs see better yields.

## Why This Matters (Especially for Beginners)

CoW AMM's design brings professional-level optimization to everyday users. You don't need to understand complicated strategies or monitor the markets constantly. Just deposit tokens, or trade when you need to - and the system handles the rest with fairness and efficiency.

For beginners, this means:

-   No need to worry about front-running or being "gamed"
    
-   Easier, smoother trades with better pricing
    
-   A safer and more welcoming introduction to DeFi
    

## Traditional Market Makers vs. AMMs vs. CoW AMMThe cryptocurrency space can often feel overwhelming, especially when you're just starting out. Between technical jargon, rapidly evolving technology, and a firehose of new platforms and tools, it's hard to know where to begin. One of the foundational innovations of decentralized finance (DeFi) that's worth understanding early on is the Automated Market Maker, or AMM.

In this guide, we'll break down what AMMs are, how they differ from traditional market makers, and how innovations like  [CoW AMM](https://cow.fi/cow-amm)  are taking this technology even further - making decentralized trading more secure, efficient, and fair.

## What Is an Automated Market Maker?

Let's start with the basics.

In traditional finance, when you want to buy or sell a stock, your trade is matched through an order book - a system that pairs buyers and sellers. This system usually requires market makers - typically large institutions or traders - who provide liquidity by offering to buy and sell assets at certain prices. Their job is to ensure smooth trading and reduce volatility.

In contrast, Automated Market Makers (AMMs) are a decentralized alternative. Instead of relying on human market makers or order books, AMMs use smart contracts (self-executing code on a blockchain) to enable peer-to-peer trading.

### Enter Liquidity Pools

Here's how it works in simple terms:

AMMs rely on liquidity pools - essentially shared pots of tokens. These pools are filled by users called liquidity providers (LPs) who deposit two tokens into the pool in equal value. For example, a common trading pair might be ETH/USDC, where someone deposits an equal dollar amount of Ethereum (ETH) and the stablecoin USDC.

These deposited tokens then become available for others to trade against. Rather than matching with another individual trader, users trade against the pool itself, and a mathematical formula adjusts the price based on the ratio of the two tokens.

### Example: The Constant Product Formula

Most AMMs, like those used in Uniswap, use a formula that looks like this:

x * y = k

Where:

-   x = amount of Token A
    
-   y = amount of Token B
    
-   k = constant (remains unchanged)
    

If someone wants to buy Token A, they must add Token B to the pool. This shifts the balance, increasing the price of Token A slightly, creating the supply-and-demand curve that you'd expect in any market.

This method ensures there's always a price and always liquidity - even if no one else is around to trade.

There are other types of pool that use different formulas to create what are called weighted pools, but in this example we're going to stick with the most common type of AMM.

## Why Are AMMs a Big Deal?

AMMs are at the heart of DeFi because they remove the need for intermediaries. Here's why they're a major innovation:

### 1. They're Always Open

Unlike centralized exchanges, which might have downtime or rely on limited liquidity during off hours, AMMs are available 24/7. As long as there's liquidity in the pool, you can trade.

### 2. Anyone Can Provide Liquidity

In traditional finance, only big players act as market makers. In AMMs, anyone with crypto can contribute to a liquidity pool and earn fees from trades - democratizing access.

### 3. They're Non-Custodial

You never give up control of your assets to a centralized platform. Everything happens on-chain, and your wallet always holds your funds until you actively interact with a smart contract.

## The Downsides of AMMs

AMMs aren't perfect. As with any tool, there are trade-offs:

### Impermanent Loss

If you provide liquidity to a pool and the price of one token changes significantly compared to the other, you might end up with less money than if you'd simply held onto your tokens. This phenomenon is called impermanent loss.

### MEV (Maximal Extractable Value)

Here's where things get a bit tricky: On public blockchains, anyone can see pending transactions. Some sophisticated bots and traders use this visibility to front-run trades - they jump ahead in line and profit from the price movements that your trade causes.

This is part of a broader problem called  [Maximal Extractable Value](https://cow.fi/learn/a-guide-to-mev-on-ethereum-explained-cow-dao?ref=learn_search)(MEV) - where someone extracts value from a block by strategically ordering transactions. And unfortunately, regular users and liquidity providers often lose out in this process.

Find out more about  [MEV and how it works here.](https://cow.fi/learn/a-guide-to-mev-on-ethereum-explained-cow-dao?ref=learn_search)

### Loss Versus Rebalancing (LVR)

[LVR](https://cow.fi/learn/what-is-loss-versus-rebalancing-lvr?ref=learn_search)  is a form of arbitrage that occurs whenever an AMM has an outdated (stale) price in comparison to some other trading venue. Arbitrageurs exploit this difference by trading from the AMM to the more liquid exchange (usually a centralized exchange like Binance), correcting the arbitrage and extracting value from LPs in the process.

Find out more about  [LVR and how it works here](https://cow.fi/learn/what-is-loss-versus-rebalancing-lvr?ref=learn_search).

## Introducing CoW AMM: A New Kind of AMM

This is where  [CoW AMM](https://cow.fi/cow-amm)  comes in - a novel approach developed by  [CoW DAO](https://cow.fi/)  that addresses some of the most pressing issues facing current AMM models.

Let's explore how this system works and why it might represent the next evolution in decentralized trading.

What Makes CoW AMM Different?

### Protection from MEV

[CoW AMM](https://cow.fi/cow-amm)  tackles MEV head-on by using batch auctions and intent-based trading.

Rather than letting every trade hit the chain instantly (and visibly), CoW AMM allows multiple trade "intents" to be submitted off-chain. Then, these intents are matched and executed together in a single batch.

Because all trades are processed simultaneously, there's no opportunity for front-running - bots can't jump ahead and exploit your trade.

This process happens through a solvers network - specialized bots that compete to offer users the best execution. It's a win-win for both users and liquidity providers.

### Capital Efficiency & Enhanced Yield

Traditional AMMs spread liquidity across the entire possible price range. That means your tokens might sit unused if no trades happen near their price.

CoW AMM allows LPs to concentrate their liquidity into targeted price ranges - making better use of capital and increasing the chance that they'll earn trading fees.

It works similarly to how index funds concentrate around certain market segments. That's why a CoW AMM - once new features have been deployed - acts as an "enhanced index fund" for DeFi - your funds are passively managed, but smartly deployed for better returns.

## Real-Life Example: CoW AMM in Action

Let's say you want to swap 1 ETH for USDC using CoW AMM.

1.  You submit an "intent to trade" - a request that says, "I want to swap 1 ETH for the best possible amount of USDC."
    
2.  Your intent goes into a batch with many others.
    
3.  CoW Protocol's solver network analyzes the best path for execution - across multiple pools, DEXs, or even aggregators.
    
4.  The batch is executed, and you receive your USDC - with less slippage, no MEV, and often a better price than on a traditional AMM.
    

As a result, users trade with confidence, and LPs see better yields.

## Why This Matters (Especially for Beginners)

CoW AMM's design brings professional-level optimization to everyday users. You don't need to understand complicated strategies or monitor the markets constantly. Just deposit tokens, or trade when you need to - and the system handles the rest with fairness and efficiency.

For beginners, this means:

-   No need to worry about front-running or being "gamed"
    
-   Easier, smoother trades with better pricing
    
-   A safer and more welcoming introduction to DeFi
    

## Traditional Market Makers vs. AMMs vs. CoW AMM
![Screenshot 2025-04-15 at 15.48.20.png](https://celebrated-gift-f83e5c9419.media.strapiapp.com/Screenshot_2025_04_15_at_15_48_20_233ef525c4.png)

## Final Thoughts: The Future of AMMs

Automated Market Makers are one of the pillars of decentralized finance. They've allowed people to trade without centralized exchanges, earn passive income through liquidity provision, and create more open financial systems.

But as with any technology, innovation is key.

[CoW AMM](https://cow.fi/cow-amm)  represents a next-generation evolution of this idea - one that's more secure, more capital efficient, and more user-friendly. By solving key problems like MEV and improving how liquidity is deployed, CoW DAO is helping build a DeFi ecosystem that truly works for everyone.

Whether you're a beginner exploring DeFi for the first time or a seasoned user looking for better tools, AMMs - and especially  [CoW AMM](https://cow.fi/cow-amm)  - are worth your attention.

### 📚 Want to Learn More?

-   [CoW DAO: The First MEV-Capturing AMM](https://cow.fi/learn/cow-dao-launches-the-first-mev-capturing-amm?ref=learn_search)
    
-   [Why CoW AMMs Act as Enhanced Index Funds](https://cow.fi/learn/why-cow-amms-act-as-enhanced-index-fund?ref=learn_search)

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AMMs power the DeFi world, but how do they work? In this guide we'll explore what makes them tick, as well as different types. 

Understanding Automated Market Makers: A Beginner’s Guide to DeFi Liquidity

![DCA.png](https://celebrated-gift-f83e5c9419.media.strapiapp.com/DCA_4012e24431.png)


Are buying the dip, or selling the news? When it comes to crypto, there are lots of different terms, ideas, and strategies to buying and selling tokens. One of the most enduring is Dollar-Cost Averaging (DCA).

  

DCA is, at its simplest, a method for buying, or selling tokens over a period of time. The idea is that by spreading out the buying and selling, you can offset the price volatility that is common in crypto markets.

  

This article explores the concept in more detail and looks at how CoW Swap’s unique programmatic orders can take the hard work out of using a DCA strategy.

## What is Dollar-Cost Averaging (DCA)?

  

Dollar-cost averaging (DCA) is a strategy that seeks to reduce the impact of market volatility when it comes to buying and selling cryptocurrencies.

  

It does this by spreading out transactions across time, either weekly, monthly, quarterly, or even annually, depending on your preferred means of buying and selling.

  

Why would you spread these out over time? The primary goal is to buy and sell assets for an average cost. Volatility is common in crypto, meaning one week you might buy an asset for $1 but the next week it could $2.

  

By spreading out the amount you buy over time, you can offset the volatility of the token. The idea is to lower the average cost per unit over time.

## How Does Dollar-Cost Averaging Work?

  

Instead of buying an asset once in a single transaction, DCA means you buy an asset multiple times. So instead of buying $100 worth of tokens in one go, you buy $10 worth of tokens every week for 10 weeks. Let’s take a look at an example.

  

You’ve got your eye on a meme coin but are waiting for the right time to buy. Using a DCA strategy would mean allocating a fixed amount of money to purchasing, irrespective of market conditions.

  

So if the price is high in your first transaction, you’ll buy fewer tokens, but when the price is low, you’ll buy more. Over time, this can result in a lower average cost per unit compared to making a one-time lump sum allocation.

## Why would I use Dollar-Cost Averaging over a single transaction?

  

A DCA strategy eliminates the need to time the market. Picking the perfect time to enter or exit a market can be challenging, even for experienced traders.

  

By allocating or selling a fixed amount at regular intervals, you remove the guesswork, and the potential stress of entering and exiting a market or asset.

  

A DCA strategy is a good option if you’re trying to minimise the average cost per unit aims to potentially lower the average cost per unit of an asset. By allocating resources regularly, you acquire more units when prices are low and fewer units when prices are high. This can result in a lower average cost per unit over time.

## Who Can Benefit from Dollar-Cost Averaging?

  

DCA is a strategy that can benefit both beginners and long-term investors. For beginners, it's a simple and disciplined approach to resource allocation that doesn't require extensive market knowledge.

  

For long-term investors, it can be a strategy that helps iron out the bumps in the market and help with longer term planning and portfolio building.

## Taking the hard work of DCAing with Programmatic orders

  

CoW Swap has a number of unique features that take the hard work out of doing DCAing manually. We call them “[Programmatic Orders](https://cow.fi/learn/introducing-the-programmatic-order-framework-from-cow-protocol)”. Programmatic Orders are, at their simplest, orders that create more orders.

  

They require just one signature to create, then execute when on-chain conditions (prices, volumes, balances, times, etc.) are met. Programmatic Orders can execute indefinitely into the future, automating everything from complex trading strategies to advanced order types, portfolio management, DAO operations, and more.

  

One particular type of programmatic order we think you’ll love is [TWAP orders.](https://cow.fi/learn/why-twap)

  

TWAPs, or Time-Weighted Average Price (TWAP) orders are a unique type of trade that lets users apply a number of different parameters to their trades.

  

TWAP orders allow traders to spread their trade over a specified period of time. In essence: a TWAP order consists of multiple smaller orders placed at regular intervals over a predefined time period. You decide on the intervals, the number of parts, and other key factors including total duration and part duration. It’s like a DCA strategy inside one single signed transaction.

  

Investors can also use TWAP to sell their positions through dollar-cost averaging. Simply switch the assets you’re swapping and TWAP will help you exit the market for an average price.

  

But it doesn’t stop there. Using CoW Swap for your DCA strategy can help you do other things too.

## When you want to sell your small cap tokens

  

Built up a war chest of small caps but can’t seem to exit? [TWAP orders](https://cow.fi/learn/getting-to-grips-with-time-weighted-average-price-twap-orders) can be useful for breaking up the trade into chunks. Trying to push large trades in small caps can often face hurdles. But with [TWAP](https://cow.fi/learn/getting-to-grips-with-time-weighted-average-price-twap-orders) you can set your trade to execute over periods as long as a month and in multiple chunks, helping you exit small caps in one go.

## When you’re trying to reduce your slippage

  

If you’re trying to keep your slippage low, using [TWAP](https://cow.fi/learn/getting-to-grips-with-time-weighted-average-price-twap-orders) to split up a large order into smaller parts allows you to use a smaller slippage tolerance for each part. [TWAP orders](https://cow.fi/learn/getting-to-grips-with-time-weighted-average-price-twap-orders) are also protected from MEV, helping protect your trades. The MEV bots can look elsewhere.

## When you want to receive 100% of your order surplus

On [CoW Swap](https://cow.fi/cow-swap), all order surplus is forwarded to you. If your order executes for a better price than your quoted price — thanks to [Coincidence of Wants](https://cow.fi/learn/what-are-cows-on-cow-swap) or any other price improvement that solvers are able to find — the extra price improvement will be forwarded to you.

## When you’re trying to navigate volatile prices

  

By giving traders the time-weighted average price, TWAP orders smooth out market volatility, which makes trying to predict prices a thing of the past.

## When you want to specify certain conditions or parameters

  

TWAP orders allow you to fine-tune your order by specifying the number of parts you’d like it split up into, as well as the time period you want it to execute over. On [CoW Swap](https://cow.fi/cow-swap), TWAP orders also have a “price protection” option which protects your order from executing at an unfavorable price due to market volatility.

  

Ready to start DCAing on CoW Swap?

  

[Starting trading today.](https://cow.fi/cow-swap)

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DCA.png

DCA is, at its simplest, a method for buying, or selling tokens over a period of time. This article explores the concept in more detail and looks at how CoW Swap’s unique programmatic orders can take the hard work out of using a DCA strategy. 


Understanding Dollar Cost Averaging in Crypto

George Hristov

# Smart contracts: how they power DeFi 

Blockchains eliminate the need for a central authority or intermediary in running a large, decentralized network of nodes. Smart contracts bring these benefits to specific use cases by enabling the creation of decentralized apps (dApps).

## What is a smart contract?

A smart contract is an executable program on a blockchain network. Smart contracts make up the backbone of the web3 industry as they enable many of the use-cases that blockchains are known for including staking, swapping, lending, borrowing, and much more.

## How do Smart Contracts Work?

Smart contracts are created as computer code that is hosted and executed on a blockchain network. A decentralized set of nodes keep a copy of the entire state of the blockchain, including all deployed smart contracts, in order to ensure that the smart contracts are executed in a reliable and transparent way.

Let’s take a look at the process of creating and deploying a smart contract:

- **Contract Creation**: Developers write smart contracts using programming languages compatible with the blockchain, such as Solidity for Ethereum. The code within the smart contracts include rules for execution and the logic necessary for the smart contract to perform its function — such as lending, swapping, borrowing, etc.

- **Compiling**: After it’s written, the smart contract is compiled into bytecode. This is the machine-readable language that execution environments such as the Ethereum Virtual Machine (EVM) use.

- **Deployment**: Once it’s compiled, the smart contract is deployed to the blockchain through a transaction that includes the contract’s code. This transaction is then broadcast to the network and assigned a unique address on the blockchain, similar to how blockchain wallets have addresses.

- **Trigger**: Smart contracts are designed to automatically execute when predefined conditions are met. They can be triggered by various events, including receiving a certain amount of cryptocurrency, the expiration of a timer, receiving a trigger from an external data source, and more.

- **Execution**: Once a contract is triggered, blockchain nodes execute the contract’s code. Since every node on the network independently runs the code, the execution is verified and validated multiple times. This multi-party validation is what provides the security and transparency smart contracts are known for.

- **State Change**: All actions taken by a smart contract are treated as transactions. These transactions can change the state of the contract, interact with other contracts, alter user balances, and more.

- **Results**: The state change caused by the execution of the smart contract is recorded on the blockchain and assimilated by the various nodes. Changes in balances, variables, ownership records, and more are recorded on the blockchain in an immutable manner.

- **Continuous Interaction**: Smart contracts can remain on the blockchain indefinitely, ready to be triggered again under the right conditions.

An important aspect of smart contracts is that they are permisionless, meaning that anyone can develop and deploy a smart contract on any public blockchain. All they have to do is pay the necessary gas fees to deploy the smart contract.

## What are Smart Contracts Used For?

Smart contracts are at the heart of decentralized apps (dApps). They power the entire world of decentralized finance (DeFi) as well as other fields like blockchain insurance, gaming, NFTs, social networks, and much more.

### Decentralized Exchanges

dApps that enable trading, like Uniswap, rely on smart contracts for processing user funds, [finding liquidity](https://cow.fi/learn/understanding-automated-market-makers-a-beginner-s-guide-to-de-fi-liquidity), and executing swaps.

More complex decentralized exchanges such as [CoW Swap](https://swap.cow.fi/#/swap?utm_source=medium&utm_campaign=smart-contracts-article) use smart contracts to power solver competitions where multiple independent parties find liquidity on behalf of users. In this case, smart contracts are essential for enforcing the rules of the competition and ensuring users get the best deal for their trades.

### Lending & Borrowing Platforms

Platforms like [Aave](https://aave.com) allow blockchain users to take out overcollateralized crypto loans without relying on traditional counterparties. These dApps utilize smart contracts to allow users to lend out their crypto assets or borrow against them.The platform works by having users deposit crypto tokens into liquidity pools managed by smart contracts and allowing borrowers to take out loans from these liquidity pools by providing collateral. Smart contracts automatically enforce the terms of the loan, such as collateral requirements, interest rates, and repayment terms. They also manage liquidations whenever necessary.

Additionally, on-chain lending platforms use algorithmically determined dynamic interest rates, which adjust based on the current supply and demand for each asset in the pools. Smart contracts calculate and update these rates in real-time, ensuring that lenders receive competitive returns and borrowers pay fair rates.

### Liquidity Providing

Exchanges that rely on [automated market makers (AMMs)](https://cow.fi/learn/understanding-automated-market-makers-a-beginner-s-guide-to-de-fi-liquidity) use smart contracts not only for the swap process, but also for allowing users to provide liquidity. [AMMs](https://cow.fi/learn/cow-protocol-glossary#:~:text=amm) allow users to trade assets without the need for a centralized intermediary, or even a traditional orderbook.

Whenever a user swaps tokens, they interact with the appropriate liquidity pool’s smart contract. The contract calculates the amount of tokens that can be received based on the current ratio of tokens in the pool, with the goal of ensuring that the pool remains balanced. The transaction is then executed automatically by the smart contract without requiring a traditional buyer-seller match.

### Staking

Many smart-contract-enabled blockchains, such as Ethereum, use proof-of-stake consensus mechanisms. These systems require users to lock up, or “stake,” tokens in order to validate the state of the blockchain. Smart contracts are essential to this process.

Tokens used for staking are locked in a smart contract that ensures that the tokens cannot be spent elsewhere while they are staked. This contract typically specifies conditions such as the minimum staking period, the minimum and maximum stake amounts, and other rules governing the staking process.

Smart contracts also calculate the rewards distribution for stakers, select which validators should create the next block, penalize validators in case of misconduct, and facilitate unstaking and withdrawals.

## What are the Benefits of Smart Contracts?

So far, we’ve seen that smart contracts ensure that dApps are online 24/7 and function without the need for counterparties. Below we take a look at some additional benefits.

-   **Automation:** Smart contracts are automatically executed, meaning they effectively eliminate counterparty risk. Various parties in transactions also have their funds transferred automatically without having to wait for signatures, notaries, or other forms of manual verification.
    
-   **Transparency:** Smart contracts deployed on blockchains are publicly visible, meaning anyone can audit the code and determine what the smart contract does. This transparency encourages trust as malicious code can be quickly identified and there is no doubt about what steps a smart contract will take when executed.
    
-   **Immutability:** As a corollary to transparency, smart contracts are also immutable, meaning that they cannot be changed without these changes becoming public. This adds an additional layer of transparency which ensures smart contracts perform what they are supposed to with no malicious code and without censoring outputs.
    

## What are the Limitations of Smart Contracts?

The main downside of smart contracts is (aptly) known as “smart contract risk” — which is the risk that the smart contract has a bug that prevents it from executing properly or puts user funds at risk.

A powerful benefit of smart contracts is their immutability, meaning no one can sneak changes in. This can also prove to be a headache, however, if a smart contract is deployed with an error. For this reason, it’s extremely important that code deployed on blockchains is as error-free as possible. In service of this goal, the cottage industry of smart contract audit services has emerged to help make sure deployed code has no bugs and smart contract risk is well managed.

## How Smart Contracts Enable Decentralized Finance

Decentralized finance, or “DeFi”, is an emerging field that aims to transform the way individuals move money, ending the reliance on centralized intermediaries like banks. A core DeFi function is the ability to swap cryptocurrencies from one to another permissionlessly. One of the leaders in this space, CoW Swap, is a [meta DEX aggregator](https://cow.fi/learn/what-is-a-meta-dex-and-why-should-you-use-it-for-your-trades) that enables the most efficient and price optimal swaps in DeFi.

![1-what-is-a-smart-contract.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/1_what_is_a_smart_contract_80275c1ffb.webp)

## How CoW swap uses smart contracts

CoW Swap relies on smart contracts for much of its functionality. Not only do smart contracts enable the nuts and bolts of processing user funds, they also govern the solver competition that sets CoW Swap apart from other decentralized exchanges.

Smart contracts ensure that CoW Swap users receive the best prices for their trades through a decentralized solver competition where independent third parties compete for the right to settle user trades. The best solution is algorithmically determined based on which solver provides the most surplus to users. Thanks to smart contracts, CoW Swap users know that they are getting the best deals for their trades.

Give CoW Swap a shot and put its smart contracts to work for you:  [swap.cow.fi](https://swap.cow.fi/#/swap?utm_source=medium&utm_campaign=smart-contracts-article.


# FAQs about smart contracts

### What makes smart contracts different from traditional contracts?

Smart contracts automatically execute when conditions are met without requiring third-party verification. They operate 24/7 on blockchain networks, eliminating counterparty risk through immutable code. Traditional contracts need manual enforcement and often involve intermediaries like lawyers or notaries to verify and execute terms.

### How are smart contracts created and deployed on blockchains?

Developers write smart contracts in languages like Solidity (for Ehereum contracts) before compiling them into bytecode. The compiled code is then deployed to the blockchain through a transaction that generates a unique address. Once deployed, the contract remains on the blockchain indefinitely, ready to execute when triggered by specific conditions.

### What are the primary risks associated with smart contracts?

Smart contract risk stems from potential bugs or vulnerabilities in the code that could compromise user funds. Once deployed, contracts cannot easily be modified due to their immutable nature on the blockchain. This is why professional audits are essential before deployment to minimize errors and protect user assets.

### How do smart contracts benefit DeFi applications like CoW Swap?

Smart contracts enable CoW Swap to run solver competitions that find the best prices for users. They process user funds securely while ensuring transactions execute automatically without intermediaries. Smart contracts also provide transparency, as anyone can verify the code's functionality, building trust in the decentralized exchange ecosystem.

### How do smart contracts enable the CoW Swap solver competition?

Smart contracts govern the rules of CoW Swap's solver competition where independent parties compete to find liquidity. They algorithmically determine which solver offers the best execution price for users' trades. This process ensures users receive optimal prices while maintaining a trusted and permissionless trading environment.

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Discover how smart contracts power DeFi, enabling decentralized apps, lending, borrowing, staking, and more on blockchain networks.


Smart Contracts: How They Power DeFi | CoW Swap

Slippage is the difference between the price at which a cryptocurrency order is submitted and the price at which it’s executed.

Since crypto prices fluctuate constantly, it’s necessary to set a “slippage tolerance” for every trade which allows users to accept a slightly higher or slightly lower price for their trades at execution time.

## What is Slippage?

Slippage is the amount that a trade price may vary by between the time the trade is placed and the time it actually executes.

To better understand slippage, let’s take a look at an example.

Let’s say a user places an order to buy 1 ETH while the price of ETH is exactly $3,000. By the time the order executes, however, ETH has shifted slightly in price and the user ends up only paying $2,980 for 1 ETH. The $20 difference between the $3,000 that they initially placed their order at and the $2,980 per ETH price that the order eventually executed for is known as slippage.

## What is a Slippage Tolerance?

![1-what-is-slippage.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/1_what_is_slippage_0b1a557216.webp)

_The slippage setting on_ [_CoW Swap_](https://swap.cow.fi/#/swap?utm_source=medium&utm_campaign=slippage-article)

Decentralized exchanges require users to set a “slippage tolerance” percentage every time they make a trade. This determines how much deviation the trader is willing to accept in the price of the asset they are trading.

For example, if a user wants to buy 1 ETH, it might cost them $3,000 at the time they place their trade, but by execution time that price may have changed to $2,950 (approximately 2% less). If they had no slippage tolerance, their trade would fail, potentially still incurring gas fees and forcing them to resubmit the transaction.

Meanwhile, if they set a slippage tolerance of 2% when they place their trade, their trade would be able to execute at prices 2% below or 2% above the quoted price. In this example, this would allow the trade to go through as long as 1 ETH is between $2,940 and $3,060 at execution time.

All decentralized exchanges use slippage tolerances for user trades, so it’s important to understand the concept and know what percentage to use.

## What Slippage Tolerance Should I Use?

As a rule, you should try to use the smallest slippage you can get away with. On most exchanges, the default slippage tolerance is between 0.5% and 2%, however, the optimal slippage tolerance depends on the type of asset you’re trading.

Generally speaking, the more volatile a crypto asset is, the higher a slippage tolerance you’ll need to use.

**For stable assets**: Assets like stablecoins generally require a low slippage tolerance because their prices don’t fluctuate by much. Exchanges specializing in stablecoins (such as Curve) set the default slippage tolerance for these assets at between 0.25% and 0.5%.

**For standard assets**: The standard slippage tolerance for most trades is between 0.5% and 2%. This is a good range to stick to when trading established assets with medium volatility profiles such as Ethereum.

**For volatile assets**: When it comes to cryptocurrencies whose prices jump wildly — such as memecoins or new token launches — users will often need to use a higher slippage tolerance than 2%. There is no hard and fast rule here. Depending on the volatility of the asset, user trades may require a double-digit slippage, maybe even in the high double-digits, in order for the trade to go through.

It’s important to understand, however, that setting a high slippage tolerance leaves you vulnerable to price exploitation in the form of maximal extractable value (MEV).

## The Dangers of High Slippage

While setting a high slippage tolerance helps ensure that your transaction goes through, using too high of a slippage tolerance can be dangerous.

Blockchains like Ethereum process transactions sequentially, meaning that transactions in a block execute one after the other. This, combined with the mechanism of  [automated market makers (AMMs)](/learn/cow-protocol-glossary#:~:text=amm), means that value-extracting bots can strategically place transactions before and after your trade to exploit your slippage tolerance and extract value from you. This type of price exploitation is known as maximal extractable value (MEV).

### Sandwich Attacks

![2-what-is-slippage.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/2_what_is_slippage_e0af2a8fb5.webp)

_The flow of a sandwich attack_

A  [sandwich attack](/learn/what-is-a-sandwich-attack-and-how-can-you-protect-yourself)  is a form of MEV that can occur whenever a user places a trade with a high slippage tolerance. Specifically, this is a slippage tolerance that is larger than what the market price may call for.

When a user places this trade, an MEV bot (known as a “searcher”) places another transaction before the user transaction, pushing the price of the traded asset up to the original user’s maximum slippage tolerance. The original user’s transaction then goes through, pushing the price up even further. Finally, the searcher sells the asset, cashing out on the price difference.

In the end, the user loses out because their transaction could have gone through at a lower slippage. Instead, the searcher forced the user’s transaction to execute at the limit of its slippage tolerance and kept the difference for themselves.

This isn’t a rare occurrence either, MEV is a systemic problem for chains like Ethereum where MEV losses total over $1.3 billion to date.

## What is Auto-Slippage?

Unfortunately, there is no perfect way to predict what the ideal slippage should be for every trade. In crypto, users are often competing against more sophisticated trading parties and bots who can take advantage of their sub-optimal traders for their own profit.

To protect users from MEV, some exchanges offer auto-slippage functions which automatically calculate the slippage tolerance that trades should use based on the assets they are trading and market conditions.

## CoW Swap: Premium Auto-Slippage and Delegated Trade Execution

![3-what-is-slippage.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/3_what_is_slippage_4170bdeb89.webp)

One of the exchanges with the most advanced auto-slippage features is CoW Swap. CoW Swap is an intents-based DEX aggregator that uses third parties known as “solvers” to execute trades on behalf of users. Solvers calculate the optimal slippage tolerance for user trades and take on all the risks of MEV.

![4-what-is-slippage.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/4_what_is_slippage_4f3c2ce1e4.webp)

In fact,  [data shows](https://blog.cow.fi/do-cows-slip-age-less-389150154f84)  that CoW Swap offers a low default slippage the overwhelming majority of the time compared to 0x and 1inch.

On CoW Swap, you can make the perfect trade every time, even if you’ve never heard of “slippage” before!

Trade worry-free at  [swap.cow.fi](https://swap.cow.fi/#/swap?utm_source=medium&utm_campaign=slippage-article).

## **FAQs**



## What is slippage in crypto?

Slippage is the difference between the price at which a cryptocurrency order is submitted and the price at which it's actually executed. For example, if you place an order to buy 1 ETH at $3,000 but the transaction completes at $2,980, the $20 difference is slippage. This occurs because crypto prices fluctuate constantly, making some price difference between order placement and execution almost inevitable.

## What is a slippage tolerance?

Slippage tolerance is the percentage deviation in price that a trader is willing to accept when executing a cryptocurrency trade. For instance, setting a 2% slippage tolerance when buying 1 ETH at $3,000 means your trade can execute as long as the final price falls between $2,940 and $3,060. Without setting an appropriate slippage tolerance, trades may fail during price fluctuations, potentially still incurring gas fees and requiring you to resubmit the transaction.

## What slippage tolerance should I use for different assets?

For stable assets like stablecoins, a low slippage tolerance of 0.25% to 0.5% is typically sufficient since their prices don't fluctuate much. Standard assets with medium volatility profiles like Ethereum generally work well with a slippage tolerance between 0.5% and 2%. Highly volatile assets such as memecoins or new token launches may require double-digit slippage tolerances to ensure trades go through, though this comes with increased risk of exploitation.

## What are the dangers of using high slippage tolerance?

Setting a high slippage tolerance can expose you to price exploitation through maximal extractable value (MEV) attacks, particularly sandwich attacks. In a sandwich attack, MEV bots place transactions before and after yours, pushing the price to your maximum slippage tolerance and then selling at the elevated price, essentially extracting value from your trade. These attacks are not rare—MEV losses on Ethereum total over $1.3 billion to date, making it important to use the lowest workable slippage tolerance.

## What is auto-slippage and how does it help traders?

Auto-slippage is a feature offered by some exchanges that automatically calculates the optimal slippage tolerance based on the assets being traded and current market conditions. CoW Swap, for example, uses an advanced auto-slippage system where third-party "solvers" calculate optimal slippage and execute trades on behalf of users, taking on all MEV risks. Data shows that CoW Swap offers lower default slippage than competitors like 0x and 1inch, allowing even beginners to trade without worrying about slippage settings.

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Slippage occurs in most crypto trades, and it’s an important concept for traders to understand


What is Slippage in Crypto?


The rise of permissionless trading venues known as decentralized exchanges (DEXs) allow users to swap between virtually any cryptocurrency assets. Navigating multiple decentralized exchanges, however, can be cumbersome and inefficient.

This is where a decentralized exchange (DEX) aggregator comes in.

## What is a DEX aggregator?

A DEX aggregator is a platform that searches multiple decentralized exchanges to find the best prices for crypto trades.

DEX aggregators are decentralized applications that search decentralized exchange trading platforms (like Uniswap, Balancer, and others) to find the best prices for any given trade. DEX aggregators have become pivotal to the world of decentralized finance (DeFi) by providing [a single trading platform for users looking to get the best deal](https://cow.fi/cow-swap) on their swaps.

## Why traders are using DEX aggregators

DEX aggregators provide a number of benefits, simplifying trading and providing better outcomes for users.

-   Better Prices: DEX aggregators look across multiple on-chain decentralized exchanges to find the best prices for any given token pair. Since most on-chain trading relies on [automated market makers (AMMs)](https://cow.fi/learn/cow-protocol-glossary#:~:text=amm), liquidity may be fragmented across various exchanges. As their name suggests, aggregators collect this liquidity in one place, giving traders the best deal for their swaps.
    
-   Convenience: By using a DEX aggregator, [traders can reliably get good prices for their trades in one place](https://cow.fi/learn/mev-transparency-ensuring-fairness-in-defi-markets) without having to check multiple exchanges.
    
-   Price Impact Protection: Fragmented liquidity can sometimes make for shallow pools, meaning large trades experience significant [price impact](https://blog.cow.fi/cow-protocol-glossary-ad7313a2c71#:~:text=Price%20Impact). Aggregators can break up trades across multiple exchanges, reducing price impact and providing better prices.
    
-   MEV Protection: In the case of intent-based DEX aggregators, solvers execute trades on behalf of users—protecting them from price exploitation in the form of [maximal extractable value (MEV)](https://cow.fi/learn/understanding-mev-protection).
    

Fragmented liquidity often makes finding the best route for trades difficult. DEX aggregators bring this liquidity back together and take the work of finding the best prices off the backs of users.

## How does a DEX aggregator work?

DEX aggregators search various sources of liquidity to find the best trade route for on-chain assets.

Since liquidity is often fragmented across various sources, different decentralized exchanges may quote different prices for the same asset. DEX aggregators “aggregate” quotes from decentralized exchanges and fulfill user orders at the best available price. Sometimes, DEX aggregators may even route a single trade across multiple decentralized exchanges to reduce [price impact](https://cow.fi/learn/cow-protocol-glossary#:~:text=Price%20impact) and [provide better execution.](https://cow.fi/learn/mev-transparency-ensuring-fairness-in-defi-markets)

## How different DEX aggregators find better prices for traders

There are multiple types of DEX aggregators and the last few years have seen ever-more advanced versions of these platforms become available.

### Traditional DEX Aggregators (such as 1inch)

![1-what-is-a-dex-aggregator.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/1_what_is_a_dex_aggregator_b90efd4ea4.webp)

_1inch DEX Aggregator_

Traditional DEX aggregators such as 1inch have been around for years. Their interfaces look very similar to those of regular decentralized exchanges. A user is presented with a swap module that takes in two cryptocurrencies: a sell token and a buy token. After the user clicks “swap,” the aggregator automatically finds the best liquidity for the trade and executes the transaction on-chain.

### Meta DEX Aggregators (such as DeFi Llama)

![2-what-is-a-dex-aggregator.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/2_what_is_a_dex_aggregator_2323d5b3ed.webp)

_DeFi Llama Meta DEX Aggregator_

**[Meta DEX](https://cow.fi/learn/what-is-a-meta-dex-and-why-should-you-use-it-for-your-trades) aggregators are a step up from traditional aggregators.** As the “meta” name implies, they aggregate DEX aggregators. This leads to better liquidity coverage across more venues, while still providing users with a single interface for their trades.

### Intent-Based DEX Aggregators (such as CoW Swap)

![3-what-is-a-dex-aggregator.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/3_what_is_a_dex_aggregator_198d1d6719.webp)

_CoW Swap Intent-Based DEX Aggregator_

Intent-based aggregators are the most advanced type of DEX aggregator out there.

They not only aggregate on-chain liquidity across exchanges and other aggregators, they also delegate execution to third parties known as “solvers.” These third parties provide additional sources of liquidity by including private inventory and, in certain cases, even matching trades peer-to-peer. This avoids protocol fees and makes for the most efficient trades in DeFi.

## Benefits of Using a DEX Aggregator

DEX aggregators provide a number of benefits, simplifying trading and providing better outcomes for users.

**Better Prices**: DEX aggregators look across multiple on-chain decentralized exchanges to find the best prices for any given token pair. Since most on-chain trading relies on  [automated market makers (AMMs)](/learn/cow-protocol-glossary#:~:text=amm), liquidity may be fragmented across various exchanges. As their name suggests, aggregators collect this liquidity in one place, giving traders the best deal for their swaps.

**Convenience**: By using a DEX aggregator, traders can reliably get good prices for their trades in one place without having to check multiple exchanges.

**Price Impact Protection**: Fragmented liquidity can sometimes make for shallow pools, meaning large trades experience significant  [price impact](https://blog.cow.fi/cow-protocol-glossary-ad7313a2c71#:~:text=Price%20Impact). Aggregators can break up trades across multiple exchanges, reducing price impact and providing better prices.

**MEV Protection**: In the case of intent-based DEX aggregators, solvers execute trades on behalf of users—protecting them from price exploitation in the form of  [maximal extractable value (MEV)](/learn/understanding-mev-protection).

Fragmented liquidity often makes finding the best route for trades difficult. DEX aggregators bring this liquidity back together and take the work of finding the best prices off the backs of users.

## What is the Best DEX aggregator?

There are a number of DEX aggregators on the market today. By market share, the most popular DEX aggregator is 1inch. **However, when it comes to innovation, [intent-based protocols like CoW Swap go the furthest.](https://cow.fi/cow-swap)**

## CoW Swap: The Leading Intent-Based Aggregator

![4-what-is-a-dex-aggregator.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/4_what_is_a_dex_aggregator_8768b6d9fb.webp)

CoW Swap is a leading innovator in the intent-based aggregator space. It’s the second most popular DEX aggregator after 1inch, and a leader among DAO & Safe wallets.

Whales and DAOs (as well as retail users) rely on CoW Swap as their aggregator of choice because CoW Swap does more than just aggregate liquidity. It also provides comprehensive [MEV protection](https://cow.fi/learn/understanding-mev-protection) and enables price optimizations — such as [CoWs](https://cow.fi/learn/what-are-cows-on-cow-swap) — that traditional aggregators can’t. Thanks to its intent-based architecture, [CoW Swap supports 22 solvers](https://docs.cow.fi/cow-protocol/concepts/introduction/solvers) that compete with each other to find the best prices for each user trade, and even provide price surplus on top.

While other aggregators claim to provide the best prices, CoW Swap’s architecture is built from the ground up to incentivize the best prices and the most surplus for trades, all in an easy-to-use, worry-free interface.

Give CoW Swap a try for yourself at  [swap.cow.fi](https://swap.cow.fi/#/swap?utm_source=medium&utm_campaign=dex-aggregator-article).

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Decentralized exchange (DEX) aggregators are used to find the best prices for user trades


Why would I use a DEX aggregator?

Since its inception, DeFi has relied on  [automated market makers (AMMs)](/learn/cow-protocol-glossary#:~:text=amm)  directly to facilitate the majority of trading volume. More recently, however, auctions have emerged as an innovative trading mechanism that addresses some of the major shortcomings of AMMs.

Below, we examine these shortcomings and compare and contrast two popular auction solutions— Dutch auctions and batch auctions.

## The Shortcomings of AMMs

CF-AMMs, first proposed by Gnosis in 2017 and later popularized by protocols like Uniswap, are a natural fit for a world of frequent token launches and volatile assets. The core function of a CF-AMM is the rebalancing of token prices as orders come in. These AMMs rely on permissionless liquidity pools to facilitate trades for any ERC-20 token pair.

Due to their design, however, CF-AMMs leave traders exposed to price exploitation in the form of  [maximal extractable value (MEV)](/learn/understanding-mev-protection). Since orders on AMMs get executed sequentially, malicious parties can re-order trades in the Ethereum mempool and take advantage of users. MEV has become a lucrative industry for the most resourceful traders out there, but those profits come directly out of the pockets of everyday users.

The propensity of AMMs to be exploited indicates that continuous-time venues may not be the ideal solution for trading on decentralized exchanges.

## The Benefits of Auctions

![1-batch-auctions-vs-dutch-auctions.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/1_batch_auctions_vs_dutch_auctions_20effdf8c3.webp)

At its core, Ethereum is an auction — each block is limited in space, so validators auction off “blockspace” to the highest bidders. It turns out that a similar mechanism works well when it comes to trading. Auctions have presented a viable alternative to continuous-time trades in a new field known as “[Order Flow Auctions](/learn/understanding-order-flow-auctions).”

There are several points to consider when examining how auctions make sense in the context of blockchains:

1.  Blockchains aren’t continuous, so trading on a continuous system doesn’t make sense. It only leads to a “first come, first serve” mode of operation that ultimately becomes a race to the bottom.
2.  Auctions work to benefit traders as there can be multiple bidders for any given order, providing better prices by aggregating fragmented liquidity.
3.  Grouping multiple orders together in an auction presents opportunities for matching liquidity peer-to-peer rather than having to tap on-chain AMMs.

Auction mechanisms are not monolithic however. There are multiple types of auctions to take into account when considering what may make the most sense for Ethereum traders.

## Dutch Auctions

![2-batch-auctions-vs-dutch-auctions.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/2_batch_auctions_vs_dutch_auctions_fbaf900f7b.webp)

_([Source](https://medium.com/coinlist/a-primer-on-dutch-auctions-525036d24d10))_

One of the most common auction mechanisms is the Dutch auction. Dutch auctions work by offering an asset at a high starting price and then lowering the price over time until a willing bidder is found. This method identifies buyers quickly, making for a fast settlement.

Trading solutions like  [UniswapX](https://blog.uniswap.org/uniswapx-protocol)  employ Dutch auctions to settle trades with the speed of a traditional AMM, but with some added benefits.

### Pros

**Solver Competition**: Multiple parties, or “solvers,” can bid on a given asset, finding the most competitive price for the user’s assets.

**MEV Protection**: Dutch auctions protect users from MEV by relying on a third party for execution, meaning the user is never exposed to an AMM where their trade could be front-run or sandwiched.

### Cons

**Centralized**: Market makers have to have the assets in their inventory, leading users to essentially be at the mercy of the liquidity that the bidding parties have on hand.

Dutch auctions provide important benefits over continuous order trading. However, they only support auctioning one token at a time and they suffer from liquidity fragmentation as liquidity for a single token is spread across various venues.

It was this problem that inspired the creation of Gnosis Protocol V1 — the precursor to CoW Swap. This protocol relied on a different auction mechanism: the batch auction.

## Batch Auctions

![3-batch-auctions-vs-dutch-auctions.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/3_batch_auctions_vs_dutch_auctions_7431306f4d.webp)

_An illustration of the batch auction mechanism on CoW Swap_

A batch auction groups together a set of orders intents and executes the entire batch as a single transaction.

This allows multiple users to trade multiple assets within a single auction (unlike Dutch auctions). Having multiple orders in a single batch even enables  [peer-to-peer swaps](/learn/what-are-cows-on-cow-swap)  which provide better prices than any on-chain venue.

Finally, while Dutch auctions rely on a price-decay bidding process, batch auctions encourage solvers to find the best execution route for each trade, incentivizing better execution rather than just the quickest settlement.

### Pros

**Solver Competition & MEV Protection**: Just like Dutch auctions, batch auctions rely on a delegated execution model where solvers compete to find the best prices for users and protect orders from MEV.

**Surplus Capturing Orders**: Batch auctions provide an extra layer of efficiency over Dutch auctions by grouping multiple orders together. This allows liquidity to be shared between orders peer-to-peer, providing better prices than any on-chain venue. When orders  _do_  have to go on-chain, batching provides gas efficiency, further contributing to savings.

**Multiple Trades Per Auction**: Batch auctions aren’t limited to just a single asset per auction. This means that a single settlement may include multiple traders, each trading a different asset.

### Cons

**Speed**: While other modes of trading settle orders instantaneously, batches have to be open for some period of time to collect orders before executing them on-chain. Speed issues can be mitigated by executing one batch per Ethereum block, making batch auctions run at the speed of Ethereum block settlement.

Batch auctions make sense as a natural fit for Ethereum, mirroring the Order Flow Auction mechanism of the block but at the dApp level. Today,  [CoW Swap](https://swap.cow.fi/#/swap?utm_source=medium&utm_campaign=dutch-vs-batch)  is the largest production-scale implementation of batch auctions for DeFi trades.

## The CoW Approach to Batch Auctions

![4-batch-auctions-vs-dutch-auctions.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/4_batch_auctions_vs_dutch_auctions_eb922dc3cf.webp)

[CoW Swap](https://swap.cow.fi/#/swap?utm_source=medium&utm_campaign=dutch-vs-batch)  utilizes batch auctions to ensure traders get optimal prices while being protected from MEV.

The process starts with traders sending signed “intent to trade” messages to an order book, which CoW Swap then groups into batches. Solvers then search both on-chain and off-chain liquidity pools for the best prices. An auction is conducted for each batch to select the solver that provides the highest price surplus (the difference between the quoted and actual execution prices) for the orders. Finally, the winning solver executes these orders on-chain, ensuring users benefit from a uniform clearing price for all assets.

The future of batch auctions lies in targeting smaller batches where one batch is equal to one Ethereum block. This mitigates all speed issues related to batch auctions, making them execute as quickly as any other type of DeFi trade.

large_Batch auctions vs Dutch auctions.png

medium_Batch auctions vs Dutch auctions.png

small_Batch auctions vs Dutch auctions.png

thumbnail_Batch auctions vs Dutch auctions.png

Batch auctions vs Dutch auctions.png

Auctions are all the rage these days… but which auction method is really the best?


Batch Auctions vs. Dutch Auctions in Crypto

Providing liquidity to automated market makers (AMMs) like Uniswap has become one of the most popular ways to earn yield in crypto.

While other yield-bearing methods like staking and lending depend on protocol economics and aggregate market demand, there is always alpha in providing liquidity. Between new token launches, incentive programs from ecosystem grants, and ever-evolving AMM models, liquidity providing is one of the most mature sectors for earning returns on crypto assets.

However, liquidity providing has one major downside: it is subject to a pernicious form of price exploitation known as loss-versus-rebalancing (LVR).

LVR is a form of maximal extractable value (MEV) responsible for more price exploitation than all other forms of MEV combined. Many liquidity providers haven’t even heard of LVR, but it costs them 5–7% of their liquidity, resulting in hundreds of millions lost each year. In fact,  **when accounting for LVR, many of the largest liquidity pools are not profitable for LPs at all**.

How can this be? Let’s examine how liquidity providing works to learn what loss-versus-rebalancing is and where it comes from.

## What is LVR

First coined by a  [team of researchers from Columbia University](https://arxiv.org/abs/2208.06046), LVR is a form of arbitrage that occurs whenever an AMM has an outdated (stale) price in comparison to some other trading venue.

Arbitrageurs exploit this difference by trading from the AMM to the more liquid exchange (usually a centralized exchange like Binance), correcting the arbitrage and extracting value from LPs in the process.

To better understand LVR as a process, however, we first need to understand the nature of automated market makers, as well as the pre-cursor to LVR — impermanent loss.

## The CF-AMM Design

Most AMMs (such as Uniswap) are examples of constant function automated market makers—CF-AMMs.

These AMMs take in two assets and automatically re-calculate prices after each trade to ensure ample liquidity at all times. As one asset gets depleted, the other must trade at a higher price in order to maintain a constant ratio where the value of all “A” tokens in a pool is equal to the value of all “B” tokens.

CF-AMMs use the constant product function  _x*y=k_  to calculate the ratio of assets, where  _x_  and  _y_  are the two tokens and  _k_  is the constant maintained. Thus, all trades on a CF-AMM can be mapped on the constant product function curve:

![1-what-is-lvr.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/1_what_is_lvr_8d10b97884.webp)

### Liquidity Positions

Let’s look at an example of providing liquidity which will help illustrate the design (and shortcomings) of CF-AMMs.

Let’s say that the price of ETH is $1,000 and we have 2 ETH worth $2,000 that we would like to earn yield on. We can start by providing liquidity to, say, an ETH-USDC pool. In order to do this, we must first split the value of our holdings into 50% ETH and 50% USDC (remember, most AMMs require LP positions to be split 50/50 between your two assets.)

> **LP Position:**   
> 1 ETH   $1,000 USDC  
> _Total value: $2,000_

Over time, we earn LP fees on this position for our service of providing liquidity to traders. So our $2,000 is slowly growing by just sitting in a liquidity pool… sounds great, right?

## Loss-Versus-Holding (Impermanent Loss)

In our example, we’re making free money off LP fees up until the moment ETH starts to move in price. This is where we risk incurring “impermanent loss” which can be thought of as the opportunity cost of our LP position compared to what we would have had if we just held the assets (without putting them in a liquidity pool). That’s right—LPing is not automatically better.

Let’s take a look at how this shakes out for our particular example:

In an extreme scenario, let’s say the price of ETH jumps from $1,000 per ETH to $4,000 per ETH. The liquidity pool will adjust so that our assets are still 50% ETH and 50% USDC.

To calculate the new position, we use the formula  [_x=√(p1ETH∗p2ETH_](https://medium.datadriveninvestor.com/impermanent-loss-in-defi-the-risks-involved-in-providing-liquidity-67c54fdf1cfc)_)_,  where _p1ETH_ represents the original price of ETH and _p2ETH_ represents the new price of ETH. Solving for  _x_  will give us the updated (dollar-denominated) value of each asset after the AMM re-calculates prices back to 50/50 in this new price environment.

The  _sqrt(1000*4000) = 2,000_, meaning that the dollar value of each asset in our liquidity pool will be $2,000 after the recalculation. This leaves us with $2,000 USDC, and 0.5 ETH in our liquidity pool, for a total of $4,000. We started out with $2,000 and we end up with $4,000 — doubling our money.

> **Original LP Position:**   
> 1 ETH   $1,000 USDC  
> _Total value: $2,000_  
>    
> **New LP Position:**  
> 0.5 ETH   $2,000 USDC  
> _Total value: $4,000_

That’s great! …until we look at what we could have made if we had just  _held_  our 1 ETH and $1,000 USDC without ever putting them in a liquidity pool in the first place.

If we had held, our 1 ETH would be worth $4,000, which in addition to our original $1,000 USDC would leave us with $5,000 net. That’s $1,000 more than what we end up with through the liquidity pool!

> **Original LP Position:**   
> 1 ETH   $1,000 USDC  
> _Total value: $2,000_     
> 
> **New LP Position:**  
> 0.5 ETH   $2,000 USDC  
> _Total value: $4,000_   
>   
> **Holding Position:**   
> 1 ETH   $1,000 USDC  
> _Total value: $5,000_

This difference is known as “divergence loss,” or, more colloquially, “impermanent loss.”

It’s “impermanent” because if the price of the assets were to return to their original value ($1,000 per ETH in our example) the loss would be reversed and the value of our LP position (excluding yield earned) would be equal to the value of a portfolio where we had just held. So impermanent loss can also be conceptualized as “loss-versus-holding.”

If we begin thinking about counterfactual scenarios where rather than LPing, we had taken some other course of action with our money, a world of possibilities opens up. The first, “loss-versus-holding,” we just covered. The second, “loss-versus-rebalancing,” is the topic at hand that we now turn to.

## Loss-Versus-Rebalancing (LVR)

In the case of impermanent loss, if an asset begins and ends a time period at the same price, there is no loss incurred by the LPs. However, it turns out that there is a portfolio scenario which would have made money even in the case of an asset beginning at and returning to the same price. This would be a “rebalancing” portfolio.

Rather than leaving your money in an AMM or simply holding, in a rebalancing portfolio you trade your way up the price curve when it’s going up and trade down when it’s going down, effectively “rebalancing” your portfolio in real time.

**“Loss-versus-rebalancing” is the difference in value between an LP portfolio and a rebalancing portfolio.**

Let’s look at another example.

### LVR in numbers

Say we start with an LP position of 1 ETH and $1,000 USDC.

Over time, the price of ETH jumps from $1,000 to $2,000. Using the  _x=√(__p1ETH∗p2ETH__)_  formula, we can calculate that our new LP holdings would consist of 0.71 ETH and $1,414 USDC, meaning we sold 0.29 ETH for $414 during the AMM recalculation. This gives us a total portfolio value of $2,828 and a loss-versus-holding value of $172.

After some more time, the price of ETH goes back down to $1,000 where it started. Here, the values of both our LP portfolio (minus fees) and our holding portfolio are equal at $2,000, with a loss-versus-holding of $0.

> **Original LP Position:**   
> 1 ETH   $1,000 USDC  
> _Total value: $2,000_  
>  
> **LP Position After Price Move**:  
> 0.71 ETH   $1,414 USDC  
> _Total value: $2,828_  
>   
> **LP Position After Price Reversion:**   
> 1 ETH   $1,000 USDC  
> _Total value: $2,000_
>      
> **Holding Position:** 
> 1 ETH    $1,000 USDC  
> _Total value: $2,000_

But what about the loss-versus-rebalancing?

![2-what-is-lvr.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/2_what_is_lvr_3902628499.webp)

[_Image Source: Delphi Digital_](https://members.delphidigital.io/learn/loss-versus-rebalancing-lvr)

When compared to a rebalancing portfolio executed on a liquid exchange such as Binance, our LP and holding portfolios underperform — even in the case where prices return to their original value.

The rebalancing portfolio starts at the same 1 ETH and 1,000 USDC. When the price of ETH goes to $2,000,  we copy the LP trade (selling 0.29 ETH), but we do so at the current market price of $2,000 through a liquid non-AMM exchange, earning $580 for the trade instead of the $414 we got on the AMM, for a net LVR of $166. Copying the same trade on the way down, we buy back our 0.29 ETH for $290, instead of the $414 we would have to pay through the AMM, netting another $124 in LVR.

> **Original Rebalancing Portfolio Position:**   
> 1 ETH   $1,000 USDC  
> _Total value: $2,000_  
>  
> **Rebalancing Portfolio Position After Price Move**:  
> 0.71 ETH   $1,580 USDC  
> _Total value: $3,160_  
>  
> **Rebalancing Portfolio Position After Price Reversion:**   
> 1 ETH   $1,290 USDC  
> _Total value: $2,290_

So the performance of our three portfolios (ignoring LP fees) looks like this:

![3-what-is-lvr.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/3_what_is_lvr_cb9ed4cb9e.webp)

### The LVR math

For any given price movement, LVR can be calculated using the formula “[_a(p-q)_](https://a16zcrypto.com/posts/article/lvr-quantifying-the-cost-of-providing-liquidity-to-automated-market-makers/)” where  _a_  is the quantity of the asset being sold,  _p_ is the “real” market price, and _q_ is the “stale” AMM price.  (_Note: “a” is a positive number when selling and a negative number when buying.)_

Unlike impermanent loss, LVR  **depends on price trajectory and volatility**. This intuitively makes sense… the more price moves there are, the more opportunities for arbitrage. The volatility of a given market can be derived using the famous “[Black-Scholes](https://www.investopedia.com/terms/b/blackscholes.asp)” options-pricing model, and is represented by  _σ_  — a lowercase sigma.

For CF-AMMs,  [instantaneous LVR can be calculated as](https://a16zcrypto.com/posts/article/lvr-quantifying-the-cost-of-providing-liquidity-to-automated-market-makers/) [_σ²/8_](https://a16zcrypto.com/posts/article/lvr-quantifying-the-cost-of-providing-liquidity-to-automated-market-makers/). There are also more complex LVR formulas which sum instantaneous LVR to find the overall LVR of any given AMM. Find these formulas, along with a technical explanation of how the numbers were derived, in  [this video](https://www.youtube.com/watch?v=XmHBiFApDXA&ab_channel=CMUCylabCryptoSeminarSponsoredbyAlgorand)  and  [this blog post](https://anthonyleezhang.substack.com/p/automated-market-making-and-loss)  by Anthony Lee Zhang, a co-author of the original LVR paper.

## LP Returns in Practice

So far, we have the concept of LVR but we’ve ignored one very important factor: LP fees. After all, LPs don’t deposit money into AMMs out of charity, they do it to earn yield.

Now that we have a reliable formula for calculating loss-versus-rebalancing, we can look at historical data to answer the question “How often do LP returns exceed LVR losses?”

Using the LVR formula, the authors of the original paper  [concluded](https://arxiv.org/abs/2208.06046)  that, in an environment of 5% asset volatility,  **a Uniswap pool would need to turnover 10% of its entire volume each day in order for LP fees of 30 basis points to offset LVR losses.**

However, we can get even more specific by retroactively looking at historical data. DeFi researcher Atis Elsts, wrote up a  [retrospective of 2023 LP returns](https://atise.medium.com/uniswap-v2-still-a-good-deal-for-liquidity-providers-a-retrospective-of-2023-11475e9d8610)  that shows real data on loss-versus-holding and loss-versus-rebalancing for ETH throughout the year.

### 2023 Loss-Versus-Holding

ETH began the year at around $1,200 and closed around $2,300. LPs outperformed a holding portfolio of 50/50 ETH/USDC by an aggregate 1–2% after fees.

![4-what-is-lvr.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/4_what_is_lvr_f07c7346db.webp)

![5-what-is-lvr.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/5_what_is_lvr_ca2c29b635.webp)

_Images: 2023 LP versus holding strategies &  2023 LP PnL over holding strategy_

### 2023 Loss-Versus-Rebalancing

Mapped alongside volatility, we can see that, as expected, loss-versus-rebalancing is highly correlated.

![6-what-is-lvr.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/6_what_is_lvr_b227cef436.webp)

Elsts mapped LVR (red line) versus expected fees on WETH/USDC Uniswap v2 positions and WETH/USDC v3 positions across three fee tiers. We can see that  v3 LP positions closely tracked LVR, while v2 positions largely outperformed it.

![7-what-is-lvr.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/7_what_is_lvr_f5972b65fd.webp)

According to Elsts, the reason for the large discrepancy between v3 and v2 positions is that v2 sees primarily “core” (non-arbitrage) trading volume while a majority of v3 trading volume is arbitrage.

![8-what-is-lvr.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/8_what_is_lvr_a4f9fb874d.webp)

![9-what-is-lvr.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/9_what_is_lvr_3d859d861e.webp)

_Images: Uniswap v2 volume makeup & Uniswap v3 volume makeup_

So here we finally get to the $500 million question: How can LPs protect themselves from LVR?

## Solutions to LVR

There are multiple proposed solutions to the LVR problem, each with its own set of tradeoffs.

**Oracle designs**: One of the most popular suggestions for solving the LVR problem involves using price oracles to feed AMMs the most up-to-date prices for assets. The oracle model is well-tested in DeFi, but an oracle-informed AMM would require significant design changes to current AMM models and introduce new problems around ensuring that the oracle always provides the most current price data.

**Decreasing block times**: Some proposals argue that  [increasing trade frequency](https://atise.medium.com/liquidity-provider-strategies-for-uniswap-v3-loss-versus-rebalancing-lvr-ee0ffdf1f937#:~:text=mitigating%20lvr)  by decreasing block times will result in even more granular arbitrage opportunities. This would theoretically increase the number of trades that arbitrageurs have to make, with the larger LP returns hopefully outpacing LVR.

**Batch auction designs**: While decreasing block times might mitigate the price lag AMMs experience, going in the opposite direction sounds even more promising. First proposed by Andrea Canidio and Robin Fritsch in the paper “[Arbitrageurs’ profits, LVR, and sandwich attacks: batch trading as an AMM design response](https://arxiv.org/abs/2307.02074v4#5.2),” a new category of “Function-Maximizing” AMMs forces traders to trade against AMMs in batches, creating a competition between arbitrageurs which eliminates LVR.

## CoW AMM

The  [CoW AMM](https://cow.fi/cow-amm)  is the first production-ready implementation of an FM-AMM and it’s designed to capture LVR on behalf of LPs, now live on [Balancer](https://balancer.fi/pools/cow).

[Backtesting research](https://arxiv.org/pdf/2307.02074v3.pdf)  conducted for a 6 month period during 2023 shows that CoW AMM returns would have equaled or outperformed CF-AMM returns for 10 of the 11 most liquid, non-stablecoin pairs.

![10-what-is-lvr.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/10_what_is_lvr_f4853d5593.webp)

The CoW AMM works by having  [solvers](https://docs.cow.fi/cow-protocol/concepts/introduction/solvers)  compete with each other for the right to trade against the AMM.

Whenever there is an arbitrage opportunity solvers bid to rebalance the CoW AMM pools. The winning solver is the one that moves the AMM curve higher.

![11-what-is-lvr.gif](https://celebrated-gift-f83e5c9419.media.strapiapp.com/11_what_is_lvr_2618a64372.gif)

[Learn more about the CoW AMM here](https://cow.fi/cow-amm), and  [contact us](https://cowprotocol.typeform.com/cow-amm-lpers?utm_content=widget-page-footerCTA-read-docs&utm_medium=web&utm_source=LVRarticle)  if you are interested in setting up a liquidity pool.

## **FAQs**


## What is Loss-Versus-Rebalancing (LVR)?

Loss-Versus-Rebalancing (LVR) is a form of MEV (Maximal Extractable Value) that occurs when an Automated Market Maker (AMM) has outdated or stale prices compared to other trading venues. Arbitrageurs exploit this price difference by trading from the AMM to more liquid exchanges, extracting value from liquidity providers in the process. LVR costs liquidity providers approximately 5-7% of their liquidity, resulting in hundreds of millions of dollars lost each year.

## How does LVR differ from impermanent loss?

Impermanent loss (also called loss-versus-holding) is the opportunity cost of an LP position compared to simply holding the assets, while LVR compares LP returns to an active rebalancing strategy. With LVR, even when asset prices return to their starting point, a rebalancing portfolio executed on liquid exchanges would have outperformed the LP position. For example, in a scenario where ETH rises from $1,000 to $2,000 and then back to $1,000, a rebalancing portfolio could end with $2,290 total value compared to just $2,000 in the LP position.

## How is LVR calculated?

LVR can be calculated using the formula "a(p-q)" where "a" is the quantity of the asset being sold, "p" is the real market price, and "q" is the stale AMM price. For constant function AMMs, instantaneous LVR can be calculated as σ²/8, where σ represents market volatility. Unlike impermanent loss, LVR depends directly on price trajectory and volatility—more price movements create more arbitrage opportunities, increasing LVR for liquidity providers.

## Do LP fees offset LVR losses?

Research shows that LP fees rarely offset LVR losses in most popular liquidity pools. According to research, in an environment with 5% asset volatility, a Uniswap pool would need to turnover 10% of its entire volume daily with a 0.3% fee to break even against LVR losses. When examining 2023 data, Uniswap v3 positions closely tracked LVR losses, while v2 positions performed better primarily because v2 sees more "core" (non-arbitrage) trading volume.

## What solutions exist for the LVR problem?

Several solutions have been proposed to address the LVR problem, including oracle designs that feed AMMs up-to-date prices, decreasing block times to increase trade frequency, and batch auction designs. The CoW AMM represents a Function-Maximizing AMM implementation that captures LVR on behalf of liquidity providers by having "solvers" compete for the right to trade against the AMM. Backtesting research shows CoW AMM returns would have equaled or outperformed traditional AMM returns for 10 of the 11 most liquid, non-stablecoin pairs during a 6-month period in 2023.

large_LVR.webp

medium_LVR.webp

small_LVR.webp

thumbnail_LVR.webp

LVR.webp

Liquidity providers lose more than $500 million to LVR every year, but what exactly is it?


What is Loss-Versus-Rebalancing (LVR)?

An MEV blocker is a piece of blockchain infrastructure that protects orders from price exploitation resulting from MEV (Maximal extractable value).

Under the hood, it’s  [RPC endpoints](https://www.quicknode.com/docs/ethereum)  that function as MEV Blockers by routing transactions through specialized mempools which protect them from MEV and even send rebates back to traders when their trades leave money on the table.

There’s a lot of moving parts when it comes to MEV blockers, so let’s break the topic down one step at a time.

## What is MEV?

An MEV blocker is a piece of software that protects user transactions from suffering MEV exploitation… but what is MEV?

MEV (Maximal extractable value) is a hidden tax on all types of Ethereum transactions. Any time you make a large trade, mint a valuable NFT, or even provide liquidity to a liquidity pool, you are at risk of experiencing price exploitation through MEV. To date, MEV has caused over $1 billion in trading losses and continues to increase by the millions each day.

![1-what-does-an-mev-blocker-do.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/1_what_does_an_mev_blocker_do_80b9b36ca6.webp)

MEV is carried out by traders known as “searchers” who monitor pending Ethereum transactions and  bribe block builders  to order the transactions in a specific order, extracting profit in the process.

Find out more about the specifics of how MEV attacks work in our  [“Understanding MEV” series](/learn/understanding-mev-protection).

## How do MEV Blockers Work?

Since MEV relies on  [reordering transactions](/learn/understanding-mev-protection)  from the order in which they were submitted to a new, more profitable order, it’s possible to cut the process short by sending transactions to a specialized network of searchers bound by unique rules that ensure favorable execution for users.

These searchers cannot frontrun or sandwich transactions. Rather, they capture value by  [backrunning](/learn/what-is-backrunning-mev-attacks-explained)  large orders and sending a large portion of the backrunning profits back to the users as a rebate. So, as a user, you’re not only protecting yourself from harmful price exploitation in the form of frontrunning and sandwich attacks, you also have someone looking out for you any time you leave money on the table.

## What is an RPC endpoint?

We mentioned earlier that under the hood, MEV blockers run through RPC endpoints. An RPC endpoint is a communication layer between the blockchain and a user’s wallet. RPC endpoints relay messages from the wallet that  [RPC nodes](https://www.alchemy.com/overviews/rpc-node)  use to add orders to the blockchain.

RPC endpoints are the perfect place for MEV protection because they are an intermediary layer between the wallet and the blockchain, safely re-routing transactions towards the specialized network of searchers we mentioned earlier, rather than letting them end up in the public  [mempool](https://www.blocknative.com/blog/mempool-intro)  where malicious searchers lie in wait.

## Order Flow Auctions for MEV Blockers

![2-what-does-an-mev-blocker-do.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/2_what_does_an_mev_blocker_do_7de134111f.webp)

MEV Blocker RPCs rely on an emerging blockchain mechanism known as  [order flow auctions](/learn/understanding-order-flow-auctions). Order flow auctions are bidding mechanisms used at various levels of the Ethereum stack which pit multiple execution parties against each other to find the one that can provide users with the best value for their transaction.

Currently, block building incentivizes MEV extraction by awarding the privileges of creating the next block to the builder who can extract the most value from the trades. Order flow auctions invert this dynamic — incentivizing auction participants (in the case of MEV blockers, this is the specialized network of searchers) to instead find as large of a rebate as possible for the user submitting the transaction. The searcher who bids the most to backrun a trade wins the auction, capturing some small value of the proceeds for themselves and sending the rest back to the user as a rebate.

## Should you use an MEV Blocker?

While many people have yet to learn about MEV blockers, they’re quickly being adopted by some of the most savvy traders to protect their trades, NFT swaps, LP positions, and more. MEV is an increasingly significant problem for traders of all sizes and MEV blockers are designed to outsmart the searchers with the latest innovations in market mechanics.

You may have heard that MEV is only a problem for large trades, but as searchers get more and more sophisticated, this is becoming less true. Searchers can also extract value from small trades, especially in volatile markets, and beginner traders are especially susceptible to price exploitation as they may not yet know how to protect themselves.

MEV blockers provide robust protection without many downsides. As a user, you install the MEV blocker through your wallet and forget about it, meanwhile it’s quietly protecting you from price exploitation and even forwarding rebates from any money your trades leave on the table.

## MEVBlocker.io — CoW DAO’s Approach to MEV Blocking

![3-what-does-an-mev-blocker-do.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/3_what_does_an_mev_blocker_do_cc9833e466.webp)

[CoW DAO](https://cow.fi/)  became a first mover in the MEV blocker space when it introduced  [MEV Blocker](https://mevblocker.io/)  (yes, we coined the term) in April of 2023.

MEV Blocker (capital “B”) is an RPC endpoint developed by CoW DAO in collaboration with  [Beaver Build](https://beaverbuild.org/)  and  [Agnostic Relay](https://agnostic-relay.net/)  that’s built to protect Ethereum transactions from frontrunning and sandwich attacks. MEV Blocker sends transactions to a mempool of searchers who bid for the opportunity to backrun the trades, sharing any profits 90/10 with users (90% to users, 10% to searchers.)

To join  [over 600,000 Ethereum users receiving more than 1,000 ETH](https://dune.com/cowprotocol/mev-blocker)  in rebates, add MEV Blocker to your wallet by following the instructions  [here](https://mevblocker.io/).

large_What does a MEV Blocker do.png

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What does a MEV Blocker do.png

MEV blockers have made headlines in the blockchain space, but what are they and how do they work?


What does an MEV Blocker do?

EIP-1271 (also known as ERC-1271) is an Ethereum improvement that enables smart contracts to validate signatures, allowing them to sign transactions just like traditional EOA wallets.

While EIP-1271 may initially seem like a niche technical bit of implementation, the standard unlocks a whole world of functionality for smart contracts, including intent-based trading, advanced order types, and every other type of blockchain interaction that requires a wallet signature.

## What is EIP-1271

EIP-1271 serves as a “[standard signature validation method for contracts](https://eips.ethereum.org/EIPS/eip-1271),” which allows smart contracts to verify whether a signature on behalf of a given contract is valid — a feature that [Externally Owned Accounts (EOA)](https://academy.binance.com/en/glossary/externally-owned-account-eoa) already have built-in. already have built-in.

Before EIP-1271, smart contracts could send transactions, but they could not sign messages like traditional wallets. EOA have private keys that they use for signatures, validating that the message came from that particular wallet. [Smart contracts, on the other hand, do not have private keys](https://cow.fi/learn/what-is-a-smart-contract); so EIP-1271 was introduced as a standard way for smart contracts to validate a signature, enabling them to also sign messages.

### EIP-1271 vs ERC-1271


“EIP-1271” and “ERC-1271” are sometimes used interchangeably as terms that refer to the same concept. Ethereum accepts ideas for changes to the Ethereum network through a proposal process, hence the name [“Ethereum Improvement Proposal” (EIP)](https://www.coinbase.com/en-ca/learn/your-crypto/what-is-an-ethereum-improvement-proposal-eip#:~:text=An%20Ethereum%20Improvement%20Proposal%20(EIP)%20is%20a%20formal%20suggestion%20for,could%20necessitate%20a%20hard%20fork.). “ERC,” on the other hand, stands for “[Ethereum Request for Comment](https://yapglobal.com/glossary/ethereum-request-for-comment-erc/)” and gets assigned to additions to the Ethereum network thatwhich do not change the underlying protocol itself.

This means that “EIP-1271” is more accurately called “ERC-1271,” as the addition does not change protocol functionality. As mentioned earlier, however, the terms are often used interchangeably.

## Why is EIP-1271 so useful?

Over the last few years, Ethereum has seen a boom in specialized smart contracts leveraging ERC-1271 to sign messages. Signed messages are necessary for various things including placing orders on decentralized exchanges using off-chain order books, verifying that a given wallet belongs to a user, and much more.

ERC-1271-enabled smart contracts, however, unlock a whole new set of use -cases. This is because the ERC-1271 “isValidSignature” method can take in any arbitrary order logic, [turning smart contract wallets into autonomous agents](https://cow.fi/learn/tutorial-creating-smart-orders-with-cow-protocol) that can automatically sign messages based on on-chain conditions.

## Use cases for EIP-1271

Let’s take a look at the various use-cases that ERC-1271 makes possible for smart contracts.

### Off-Chain Order Books

One of the most common uses of ERC-1271 involves orders on decentralized exchanges (DEX’s). Some exchanges, like CoW Protocol and Matcha, use an off-chain order book to collect signed messages before they become orders, allowing for additional optimizations. For smart contracts to be able to trade using these systems, they need ERC-1271 to validate signatures.

Limit orders in particular are a common type of DEX order that relies on an off-chain order book, so smart contracts require ERC-1271 in order to place limit orders.

### Sign-to-Verify

Authentication is a necessity in web3.

Many web3 applications require users to sign a message proving that they control a connected wallet in order to use the application. Meanwhile, NFT marketplaces such as OpenSea and Rarible, require users to sign a message to place bids, update profile images, and perform other gas-less transactions.

In both of these cases, smart contract wallets leverage ERC-1271 to sign verification messages.

### Intents for Smart Contracts

Many DeFi solutions have begun relying on [intents](https://docs.cow.fi/cow-protocol/concepts/introduction/intents) to provide users with better prices, MEV protection, advanced order types, and many other benefits.

CoW Protocol is a [meta DEX](https://cow.fi/learn/what-is-a-meta-dex-and-why-should-you-use-it-for-your-trades) aggregator that pioneered many use cases of intents, all of which rely on signed messages. Regular EOA orders are signed ahead of time, but thanks to ERC-1271, smart contract orders can hold off on the order signature until settlement time and check that conditions such as oracle prices, current balances, block times, and more are met before the trade goes through. This unlocks a number of unique trading strategies that are only available through smart contract wallets.

### Milkman for Safe Trading

In collaboration with the  [CoW Grants program](https://grants.cow.fi/), the  [Yearn.fi](https://yearn.fi/)  team launched  [Milkman](/learn/what-is-milkman-cow-swaps-solution-for-delayed-execution-trading)  to streamline DAO trades and protect them from MEV. The DAO governance process means that significant time passes between when a trade is proposed and when the trade is actually executed. During this time, the market can move, invalidating the trade, or worse — an MEV searcher can lie in wait for the exact trade time and manipulate prices to exploit the trade.

Milkman provides a solution by allowing the DAO to specify a price feed which the smart contract checks at the moment of execution, making a trade based on the up-to-the-second price of the asset.

This means that DAOs no longer have to commit to an execution price ahead of time, but can leverage smart contracts and EIP-1271 to make a conditional order whose price is decided at the moment of execution.

###Advanced Order Types

Smart contract signatures on CoW Protocol allow for a number of advanced order types. One notable example is CoW Protocol’s  [TWAP orders](/learn/cow-swap-launches-twap-orders), which use ERC-1271 smart contract signatures to place orders in even time intervals autonomously. 

###The Programmatic Order Framework

The  [Programmatic Order Framework](/learn/introducing-the-programmatic-order-framework-from-cow-protocol)  from CoW Protocol takes full advantage of ERC-1271 by allowing anyone to code custom order logic for any type of order.

Programmatic orders execute indefinitely into the future based on on-chain conditions. These conditions can include any arbitrary logic including checking on-chain prices, smart contract wallet balances, block times, volumes, and more.

There are already a number of deployed use-cases for ERC-1271-enabled programmatic orders including:

-   Automated DAO operations including payroll, treasury diversification, and fee collection
-   Portfolio rebalancing based on the state of assets in a smart contract wallet
-   Special order types including stop-loss, good-after-time, and take-profit

### Any Application Requiring a Signature

We’ve covered a number of the use-cases that require signed messages, but ERC-1271 enables a potentially limitless number of uses… Any time a smart contract wants to use an application that requires a wallet signature, they need ERC-1271.

Here are a few final examples requiring signatures:

-   [Gasless Trading](https://cow.fi/learn/announcing-gasless-approvals-on-cow-swap): Some decentralized exchanges leveraging intents have begun offering “gasless trading,” a feature that allows users to make trades without paying for gas in ETH. On CoW Protocol, for example, all trades take gas fees in the sell token, leveraging signed messages to specify the order details.
    
-   [Native Token Flow](https://docs.cow.fi/cow-protocol/tutorials/cow-swap/native): On CoW Protocol, users can trade ETH natively without using the ERC-20 “WETH” wrapped version. Signed messages enable this which specifies the order details while bonded third parties ([solvers](https://docs.cow.fi/cow-protocol/concepts/introduction/solvers)) handle the execution.
    
-   Web3 Login: Services such as [Dynamic.xyz](https://www.dynamic.xyz/) build account abstraction functionality, allowing users to use decentralized apps with just a traditional web2 email address. These services heavily rely on ERC-1271 when using smart contract wallets to provide full signing functionality.
    

## How EIP-1271 works

With the introduction of ERC-1271, smart contracts can now define an “isValidSignature” method, which determines the conditions necessary for the smart contract to verify a signature and execute a transaction.

This implementation gives smart contracts a leg up over EOAs when signing transactions. This is because the “isValidSignature” method can include any arbitrary logic, allowing each smart contract to define its own parameters for generating a valid signature.

Some example criteria for returning a valid “isValidSignature” include:

-   Signatures from a set of hard-coded EOA addresses (used in Safe’s multi-signature model)
-   On-chain conditions like time passing between orders or reaching a given oracle price

If the owners of the smart contract would like to delegate the order placement to someone else, they can code the necessary conditions for validating a signature in the “isValidSignature.” Whenever anyone calls the smart contract, it will check these conditions and only execute when they are met.

![1-eip-1271-explained.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/1_eip_1271_explained_120c3a7916.webp)

### ERC-1271’s “isValidSignature” method

The method takes a “bytes32 hash” representing an order hash and an arbitrary byte array which is where the conditions for the signature go. This array can be any number of things — an EOA signature from an owner or delegate of the smart contract, the smart contract checking an oracle or an on-chain state to determine if the order should execute, or any other arbitrary logic.

Finally, the “isValidSignature” method returns a response that determines whether the order should execute.

In essence, the entire signature verification process looks like this:

![2-eip-1271-explained.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/2_eip_1271_explained_1ec1facfc7.webp)

### ERC-1271’s signature verification process

We create an order that needs to be signed

![3-eip-1271-explained.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/3_eip_1271_explained_f916ef6bed.webp)

The order generates an order hash

![4-eip-1271-explained.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/4_eip_1271_explained_b692a01062.webp)

The smart contract’s “isValidSignature” method is called with the hash and signature passed in as parameters

## EIP-1271: Enabling the future of smart contract trading

As Ethereum adoption grows, the needs of traders become more complex, eclipsing the built-in functionality of traditional EOAs. ERC-1271 opens the door to a new set of primitives for trading using [smart contracts, which can create autonomous, conditional orders](https://cow.fi/learn/tutorial-creating-smart-orders-with-cow-protocol) that provide much greater trading power for users.

[CoW Protocol](https://cow.fi/cow-protocol) is at the forefront of innovations relying on ERC-1271, and you can already take advantage of new order types today by swapping on [CoW Swap](https://swap.cow.fi/#/swap?utm_source=medium&utm_campaign=EIP-1271-article) or by developing custom solutions through the [Programmatic Order Framework](https://hackmd.io/pmZX_qT2Q1yw59KiiT6TPQ) (also known as ComposableCoW).

As always, happy trading!

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Discover EIP-1271, an Ethereum upgrade that enables smart contracts to validate signatures and sign transactions.

EIP-1271 Explained

Batch auctions are a powerful trading mechanism for settling orders on decentralized exchanges. Recently, batch auctions have attracted attention in the DeFi space thanks to a host of benefits including better prices and built-in MEV protection.

In this article, we’ll take a look at how batch auctions work, why they’re important, and how CoW Protocol, one of the leading innovators in the DeFi space, is leveraging batch auctions as a decentralized exchange aggregator.

## What is a batch auction?

![1-understanding-batch-auctions.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/1_understanding_batch_auctions_bdc2352d7f.webp)

A batch auction is a trading mechanism that groups orders together into “batches” and “auctions” them off to execution parties who compete against each other to find the most optimal order settlement path.

Grouping trades together allows batch auctions to enforce certain execution rules that prevent MEV attacks. The competition between execution parties makes batch auctions a type of “[order flow auction](/learn/understanding-order-flow-auctions),” meaning they are designed to find optimal prices for user trades.

In  order to find the best prices for the orders in a given batch, the execution parties (commonly known as “[solvers](https://docs.cow.fi/cow-protocol/concepts/introduction/solvers)”) aggregate liquidity from as many sources as possible — AMMs, private off-chain liquidity, and even by routing swaps peer-to-peer between the orders in a batch.

To really understand how batch auctions work under the hood, however, we must first consider how trading takes place on decentralized exchanges (DEX’s).

### How decentralized exchanges work

Due to the volatility of crypto markets, traders have to set a “slippage tolerance” every time they make a trade on a decentralized exchange. The slippage tolerance specifies the price deviation that traders are willing to accept for the assets in their order. Slippage is necessary because it accounts for changes in price between the time traders place an order and the time the order gets executed.

Decentralized exchanges rely on automated market makers ([AMMs](/learn/cow-protocol-glossary#:~:text=amm)) to provide liquidity for trades. AMMs settle trades sequentially, meaning that every order gets executed individually as it comes in. While AMMs ensure a smooth and continuous flow of transactions, their design leaves room for MEV as malicious parties can force trades to execute at a maximum slippage tolerance, giving traders worse prices than they would normally get.

This is where batch auctions come in.

## How batch auctions mitigate the MEV problem

At its core, MEV relies on  [reordering transactions](/learn/what-is-a-sandwich-attack-and-how-can-you-protect-yourself)  from the way they were submitted to a new, more profitable order. Malicious traders, known as “searchers,” monitor the Ethereum mempool — a holding area where transactions accumulate before they are included in a block and confirmed on-chain — and bribe block builders to strategically place transactions to their advantage.

Orders in a batch are executed as a single transaction, rather than sequential transactions, giving solvers tools they can leverage to keep trades safe from MEV.

**Uniform Clearing Prices**: MEV relies on reordering transactions such that sequential orders clear for slightly different prices. Searchers pocket the differences between these prices as arbitrage. With batch auctions, multiple orders trading the same token pair (such as ETH-DAI) within a single batch clear for the same price. This makes transaction reordering useless, bypassing the risk of MEV.

**Coincidence of Wants (CoWs)**: If traders in a batch are trading opposite assets, they may be matched peer-to-peer in a “[Coincidence of Wants](/learn/what-are-cows-on-cow-swap)” trade. For example, if one user is selling ETH for DAI and another is selling DAI for ETH, the two traders can simply swap assets. This provides better prices and bypasses MEV, as orders don’t have to tap on-chain liquidity.

**Enforcing the Ethereum Best Bid Offer (EBBO):**  Thanks to the competition for execution, batch auctions guarantee that the settlement solution is at least as good as the on-chain price a user could get directly by going directly to an AMM.

## CoW Protocol’s batch auction process explained

CoW Protocol, an innovative DEX aggregator,  [leverages batch auctions](/learn/navigating-the-evolution-of-cow-swap-from-market-orders-to-programmatic-orders)  to provide optimal trading prices and  [protect traders from MEV](/learn/how-cow-swap-solves-the-mev-problem).

![2-understanding-batch-auctions.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/2_understanding_batch_auctions_4462e85993.webp)

Trades on CoW Protocol begin as signed “[intent to trade](/learn/cow-protocol-glossary#:~:text=Intent%20to%20Trade)” messages that get sent to an orderbook. From here, the protocol groups these intents into batches and invokes  [solvers](https://docs.cow.fi/cow-protocol/tutorials/solvers)  for the actual order execution. Solvers search all available on-chain liquidity, and even tap off-chain liquidity, to find the most efficient execution route for the batch.

Once the protocol gathers orders in a batch, it runs an “auction” to pick the winning solver that gets to settle the batch on-chain. The winner is picked based on which solver can offer the most price surplus for the orders in the batch (surplus is defined as the positive difference in price between the quoted price and the actual execution price.) Finally, the winning solver executes the orders in the batch on-chain on behalf of the users.

Thanks to frequent batch auctions, CoW Protocol guarantees a uniform clearing price for all assets, allows trades to be matched peer-to-peer in Coincidences of Wants (CoWs), and also provides several other unique benefits including:

-   Gas optimizations thanks to reduced overhead when executing multiple orders in a single transaction
-   No deposits or withdrawals into an exchange contract, meaning that all balances are credited directly to user accounts atomically in a single Ethereum transaction
-   Fair, decentralized settlement in which an open competition for order matching replaces a central operator or a constant function market maker

### An example batch auction on CoW Protocol

To demonstrate the power of batch auctions, let’s take a look at an example involving a typical batch on CoW Protocol.

![3-understanding-batch-auctions.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/3_understanding_batch_auctions_a5b9ca70ad.webp)

For this example, we’ll take a look at  [a batch from January 2024](https://explorer.cow.fi/tx/0x6b905fb7bc096520594fda48648dcb82fa0503b1bcbe0faf906ca7290104d950?tab=orders&vis=transfers). In this settlement, a solver executed five different trades as a single batch, forming several CoWs and leveraging on-chain liquidity to fill the orders the rest of the way.

The batch began with traders trading DAI for ETH in the first two orders and the reverse — ETH for DAI — in the third order.

![4-understanding-batch-auctions.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/4_understanding_batch_auctions_9c95ead419.webp)

This inverse-swap allowed for a Coincidence of Wants. The third order was for ~500 ETH, while the first two orders were only for ~216 ETH, so the solver was able to fill the first two orders entirely using the third order’s liquidity. In return, the third order received ~216 ETH’s worth of DAI and the solver went to an on-chain AMM ([0x in this case](https://etherscan.io/tx/0x6b905fb7bc096520594fda48648dcb82fa0503b1bcbe0faf906ca7290104d950)) to source liquidity for the remaining DAI it needed to fill.

![5-understanding-batch-auctions.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/5_understanding_batch_auctions_7d79cdfbf9.webp)

The last two orders in the batch traded USDC for ETH. The solver executed both of these orders on-chain, but they still received a better price than quoted because they executed in a single batched transaction, saving on gas fees and protocol fees.

![6-understanding-batch-auctions.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/5_understanding_batch_auctions_a1edd33980.webp)

In the end, not only did batch auctions protect these orders from MEV, they also allowed the solver responsible for executing the batch to provide each order with price surplus.

A few percentage points may not seem like much, but the surplus amounts to almost $20,000 across all orders in this batch. This is money that would have been left on the table in a traditional AMM.

![7-understanding-batch-auctions.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/6_understanding_batch_auctions_f44757a473.webp)

## Batch auctions: The future of fair trading

Batch auctions are gaining notoriety as a mechanism for ensuring optimal price discovery and protecting orders from MEV.

While CoW Protocol has built an innovative frequent batch auction mechanism for DeFi trades, there are still improvements that can further protect users. In particular, CoW Protocol is looking forward to experimenting with batch time lengths that are equivalent to block time lengths. This would ensure that each CoW Protocol batch executes 1:1 with each Ethereum block, providing uniform clearing prices on the block level, rather than just the batch level, further mitigating MEV.

To experience the power of batch auctions for yourself, give  [CoW Swap](https://swap.cow.fi/#/swap?utm_source=medium&utm_campaign=batch-auctions-article)  a try for your next trade on Ethereum or Gnosis chain.

Happy batching!

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Batch Auctions.png

Batch auctions provide a host of benefits including MEV protection and better prices, but how do they really work?


Understanding Batch Auctions

MEV, or maximal extractable value, is a form of price exploitation that acts as a “hidden tax” on Ethereum transactions.

To date, MEV has caused over a billion dollars in losses for everyday traders, especially beginners who often don’t know how to protect themselves.

![1-understanding-mev-protection.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/1_understanding_mev_protection_5c36d92e50.webp)

In this article we’ll take a look at what MEV is and explore some of the popular protection solutions.

## What is MEV protection?

MEV protection refers to a broad set of strategies that keep users safe from price manipulation when trading, providing liquidity, minting NFTs, and more.

### What exactly are you protecting against?

To understand MEV, we must first understand how Ethereum transactions are processed.

![2-understanding-mev-protection.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/2_understanding_mev_protection_9bb7157306.webp)

When a user places an order, it initially gets submitted to a holding area for pending Ethereum transactions known as the “mempool.” Transactions in the mempool are public, meaning that [MEV bots (known as “searchers”) can monitor them for exploitation opportunities.](https://cow.fi/learn/mev-bots-switch-from-searcher-to-solver). MEV relies on reordering transactions from the order in which they were submitted to a new, more profitable order.

**Example: sandwich attacks**

To better understand this process, let’s trace the flow of a sandwich attack — the worst type of MEV.

![3-understanding-mev-protection.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/3_understanding_mev_protection_b1a61b2259.webp)

Essentially, traders place orders on  [AMMs](/learn/cow-protocol-glossary#:~:text=AMM)  by designating a  [slippage tolerance](/learn/cow-protocol-glossary#:~:text=Slippage%20Tolerance). Searchers can exploit these orders by placing similar trades before and after the user trade, manipulating the price of the assets on the AMM and forcing the victim trade to execute at a higher price.

Searchers pocket this difference in price for themselves. Their only cost is the amount of money they spend bribing the Ethereum block builders to order the transactions in a specific way.

To learn more about the different types of MEV, check out our articles on  [sandwich attacks](/learn/what-is-a-sandwich-attack-and-how-can-you-protect-yourself),  [frontrunning](/learn/what-is-frontrunning), and  [backrunning](/learn/what-is-backrunning-mev-attacks-explained).

**How to protect yourself from MEV**

Now let’s take a look at methods and tools you can implement to guard against MEV exploitation.

## Slippage tolerance and MEV protection

The most basic defense against MEV is setting a low slippage tolerance.

Since [MEV relies on slippage for price manipulation](https://cow.fi/learn/what-is-slippage-in-crypto), transactions with a lower slippage tolerance give searchers less room to exploit trades.

For users who aren’t utilizing any other MEV protection tools, setting a lower slippage tolerance can be a good first line of defense, however it’s by no means a complete solution. Setting the slippage tolerance too low often results in failed transactions. Even with optimal slippage, MEV bots may still be able to extract value from your trades.

## RPC endpoint tools for MEV protection

A better protection method is to install an MEV protection RPC endpoint.

A Remote Procedure Call (RPC) endpoint is an intermediate layer that routes transactions from a user’s wallet to the blockchain itself. Transactions pass through RPC endpoints before getting to the mempool, so RPCs can provide additional functionality across any blockchain application or protocol.

Normally, RPCs are a boring piece of blockchain infrastructure. Recently, however, specialized RPCs have begun incorporating extra security guarantees for transactions before they reach the blockchain.

### MEV Blocker

One of the most popular specialized RPC endpoints is  [MEV Blocker](https://mevblocker.io/).

As the name suggests, [MEV Blocker provides protection against MEV across all of Ethereum](https://cow.fi/learn/mev-blockers-explained-how-they-protect-users). The RPC works by managing a permissionless network of searchers and hiding transactions from the public mempool. These searchers cannot frontrun or sandwich user transactions. Instead, they capture value through  [backrunning](/learn/what-is-backrunning-mev-attacks-explained).

Anytime a searcher backruns a user’s transaction, the searcher keeps up to 10% of the value and sends the other 90% back to the user as a rebate. So even when a transaction leaves money on the table, MEV Blocker puts it back into the pockets of users.

MEV Blocker provides protection for any type of Ethereum transaction (not just swaps), and it works with all Ethereum wallets. Install the MEV Blocker RPC endpoint by following the instructions  [here](https://mevblocker.io/).

## Decentralized applications and MEV protection

While RPC endpoints provide significant MEV protection, the most complete protection comes at the application layer.

As MEV has become more prevalent, decentralized applications (especially [decentralized exchanges — DEX’s](https://cow.fi/learn/how-cow-swap-solves-the-mev-problem)) have begun offering creative protection solutions to users. For example, many DEXs offer an “auto-slippage” feature which determines the optimal slippage for user trades, reducing the chances of price exploitation.

### Native MEV protection on CoW Protocol

CoW Protocol is a meta [DEX aggregator](https://cow.fi/learn/what-is-a-dex-aggregator) that finds the best prices for trades and provides comprehensive MEV protection. The protocol uses [a unique trading mechanism that relies on batch auctions](https://cow.fi/learn/understanding-batch-auctions) and [intents](https://cow.fi/learn/cow-protocol-glossary#:~:text=Intent%20to%20Trade) to achieve the best outcomes for users.

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Starting at the application level, CoW Protocol provides end-to-end MEV protection through its unique protocol design:

**Delegated Trade Execution:** On CoW Protocol, [bonded third parties known as “solvers” execute transactions on behalf of users.](https://docs.cow.fi/cow-protocol/concepts/introduction/solvers) Solvers source liquidity across multiple DEX’s and even offchain liquidity sources to find the best prices for any given trade. Solvers also execute transactions on behalf of users, meaning they are never exposed to the blockchain directly.

**Coincidences of Wants**  **(CoWs)**: Thanks to CoW Protocol’s batching mechanism, trades may be matched using peer-to-peer liquidity in a  [Coincidence of Wants (CoW)](/learn/what-are-cows-on-cow-swap). This method of trading bypasses AMMs, reducing fees and preventing MEV.

**Uniform Clearing Prices:** Another benefit of batching is that [duplicate trade pairs within a given batch clear for the same price](https://cow.fi/learn/what-is-price-improvement-and-why-is-it-unique-to-cow-swap). For example, if multiple users are trading ETH and USDC in the same batch, the assets will execute for the same price across the various trades. This makes transaction reordering useless, removing the opportunity for price exploitation.

Thanks to a powerful combination of delegated trade execution, batch auctions, and protected transaction flow through MEV Blocker, CoW Protocol users benefit from thorough MEV protection on all trades.

## CoW DAO protects you from MEV

MEV is a billion dollar problem for the Ethereum ecosystem. CoW DAO builds products to protect users from negative outcomes for transactions of all types and sizes.

DeFi traders can rely on  [CoW Swap](https://swap.cow.fi/#/swap?utm_source=medium&utm_campaign=understanding-mev-article)  as the most trusted decentralized exchange when it comes to MEV protection. For all other use-cases, including liquidity providing, NFT trading, and more,  [MEV Blocker](https://mevblocker.io/)  provides extensive MEV protection anywhere on Ethereum.

If you want to learn more about MEV, check out “[MEV Transparency: Ensuring Fairness In DeFi Markets](/learn/mev-transparency-ensuring-fairness-in-defi-markets)” and “[How CoW Swap solves the MEV problem](/learn/how-cow-swap-solves-the-mev-problem).”

Safe trading!

## **FAQs**




## What is MEV and why is it harmful?

MEV (maximal extractable value) is a form of price exploitation that acts as a "hidden tax" on Ethereum transactions. It has caused over a billion dollars in losses for everyday traders, especially beginners who don't know how to protect themselves. MEV relies on reordering transactions from their original submission order to a more profitable arrangement, allowing exploiters to extract value from unsuspecting users.

## How do sandwich attacks work?

Sandwich attacks occur when MEV bots (searchers) monitor pending transactions in the mempool and exploit a trader's slippage tolerance. The searchers place similar trades before and after the user's trade, manipulating the asset price on the AMM and forcing the victim's trade to execute at a higher price. The searchers pocket the price difference, with their only cost being the bribes paid to Ethereum block builders to order transactions in their preferred way.

## What are some basic methods to protect against MEV?

Setting a low slippage tolerance is the most basic defense against MEV since it gives searchers less room to exploit trades. Users can also install specialized MEV protection RPC endpoints like MEV Blocker, which hides transactions from the public mempool and works with a permissionless network of searchers who cannot frontrun or sandwich user transactions. For comprehensive protection, using decentralized applications that offer native MEV protection features like auto-slippage is recommended.

## How does MEV Blocker protect users?

MEV Blocker is a specialized RPC endpoint that provides protection against MEV across Ethereum by managing a network of searchers and hiding transactions from the public mempool. These searchers cannot frontrun or sandwich user transactions but can capture value through backrunning, with 90% of the value returned to users as rebates. MEV Blocker works with all Ethereum wallets, protects any type of Ethereum transaction (not just swaps), and can be installed by following instructions on their website.

## How does CoW Protocol provide MEV protection?

CoW Protocol is a meta DEX aggregator that provides comprehensive MEV protection through its unique design. It offers delegated trade execution where bonded third parties called "solvers" execute transactions on behalf of users, finding the best prices across multiple DEXs. The protocol facilitates peer-to-peer liquidity matching through Coincidences of Wants (CoWs), bypassing AMMs and preventing MEV. Additionally, it implements uniform clearing prices within batches, making transaction reordering useless and eliminating price exploitation opportunities.

Line chart: from October 2020 to January 2023, MEV cumulative gross profit has risen to $1.3 billion. Within the first quarter alone, MEV profits went from zero to more than $0.5 billion."

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Ethereum users still don’t know how to protect themselves against MEV. Here are tools, methods, and apps to defend your trades from exploitation.


Understanding MEV Protection

**Intent to Trade:** When users submit orders on CoW Swap, they are not actually initiating a blockchain transaction, like they would on Uniswap. Instead, orders are submitted as signed “intent to trade” messages which include the details of the intended trade, but are not actually submitted to the blockchain. From here, independent parties known as “[solvers](https://docs.cow.fi/cow-protocol/tutorials/solvers)” find the best execution path for the specified trade and execute the trade on-chain on behalf of the user. If a trade route cannot be found for any reason, the transaction will not execute and the user will not be charged a fee for the failed transaction.

**Delegated trade execution**: When it’s time to actually execute a settlement (which can contain multiple trades),  [solvers](https://docs.cow.fi/solvers/solvers)  lock in the execution path and submit the transaction to the blockchain. Note here that it is the solvers who are completing the transaction on behalf of the user, meaning that they determine the correct slippage tolerance to use, the right amount of gas fees, as well as taking on the risk of negative price movements or MEV.

The delegated trading model also means that traders using CoW Swap do not have to spend ETH to cover gas. Instead, gas fees come out of the sell token when making trades.

**AMM**: Automated Market Makers, also known as “DEXs,” are trading mechanisms that allow traders to buy and sell assets in real-time. Unlike traditional “orderbook” trading, which relies on counterparties for every transaction (you need a seller in order to buy and a buyer in order to sell), AMMs work by maintaining a constant ratio between the prices of two assets. For example, ETH and COW. AMMs use the formula “x*y = k” to determine a fair price based on the ratio between two assets (x and y) in the liquidity pool.

Any time a trade alters this ratio by depleting the supply of one asset and increasing the other, the prices of the assets adjust in order to preserve the established ratio. For instance, if a trader buys COW and sells ETH, the COW price rises and the ETH price falls. The opposite happens when traders sell COW and buy ETH.

**Slippage Tolerance**: When placing a trade, traders set a “slippage tolerance” for their transactions which represents the maximum price difference they’re willing to accept for their trade. For example, if ETH is trading at $2,000 and you place an order to buy ETH with a 5% slippage tolerance, you’re willing to buy ETH at up to $2,100. If ETH goes above $2,100, however, your trade will fail as it’s outside your slippage tolerance.

Some amount of slippage tolerance is always necessary because the prices of crypto assets are constantly fluctuating. By the time your trade executes, the price may have moved. Setting your slippage tolerance too high, however, leaves room for searchers to sandwich your trades.

**Price Impact**: Crypto markets, like all markets, are based on supply and demand. AMMs maintain “liquidity pools” of assets which they use to fill trades. Each trade drains some amount of this liquidity and moves the asset's price. This price movement is known as “price impact.”

The larger the trade, the bigger the price impact. A trade of $100 ETH will not move the price of ETH very noticeably, since it only makes up a tiny fraction of the available liquidity. A trade of $1,000,000 ETH, however, will noticeably move the price of ETH.

**Transaction Reordering**: Blockchain transactions do not always enter the block in the order that they were submitted. Searchers can “bribe” the validators responsible for creating the block to get them to arrange transactions in a specific sequence. This transaction reordering is what makes all of MEV possible.

**EOA Wallets:**  Externally owned accounts (EOAs) are Ethereum accounts controlled by private keys. EOA wallets — for example: MetaMask, Rainbow, and Rabby Wallet — allow users to (1) send, hold, and receive Ethereum-native tokens, and (2) interact with smart contracts. Unlike smart contract wallets, EOA wallets are usually generated with a seed phrase and do not have any code associated with them.

**Milkman**: The  [Milkman](https://github.com/charlesndalton/milkman)  smart contract ensures trades are executed for the real-time price or better by utilizing a price checker, such as a Uniswap pool or an oracle. Instead of setting a fixed slippage tolerance based on the current market price, DAOs can utilize Milkman to determine a maximum percentage deviation from a real-time price sourced from a price checker, guaranteeing that their trade will finalize at a fair market price. If a trade can’t be executed within the defined price or better, the order remains pending until the price condition is met, or until the trader cancels the order.