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George Hristov

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.

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

Smart contracts were first popularized with the launch of the Ethereum blockchain in 2015. Ethereum also includes a programming language for creating smart contracts known as “Solidity.”

## 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, 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 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 managing 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) use smart contracts not only for the swap process, but also for allowing users to provide liquidity.

[AMMs](/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, slash (penalize) validators in case of misconduct, and facilitate unstaking and withdrawals.

**In summary, smart contracts are crucial to the functions of modern-day blockchains.** They ensure these systems run according to certain rules, with no down-time, and with set rules for processing all submitted transactions. All with no centralized control or trusted intermediary!

## 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 that they are immutable, 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.

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

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 that enables the most efficient and price optimal swaps in DeFi.

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).

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Smart Contracts enable the majority of decentralized apps and are critical to modern blockchain ecosystems


What is a Smart Contract?

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).

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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?


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

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.

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 on their swaps.

## 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](/learn/cow-protocol-glossary#:~:text=Price%20impact)  and provide better execution.

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

![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

![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 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

![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.

## 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](/learn/understanding-mev-protection)  and enables price optimizations — such as  [CoWs](/learn/what-are-cows-on-cow-swap)  — that traditional aggregators can’t. Thanks to its intent-based architecture, CoW Swap supports 22 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


What is 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.

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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.

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

medium_What does a MEV Blocker do.png

small_What does a MEV Blocker do.png

thumbnail_What does a MEV Blocker do.png

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 at first EIP-1271 may seem like a niche technical bit of implementation, the standard unlocks a whole world of functionality for smart contracts that includes 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 gives smart contracts the ability to verify whether a signature on behalf of a given contract is valid — a feature that Externally Owned Accounts (EOA) 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 which they use for signatures, validating that the message came from that particular wallet. Smart contracts, on the other hand, do not have private keys, 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). “ERC,” on the other hand, stands for “Ethereum Request for Comment” and gets assigned to additions to the Ethereum network which 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 a variety of 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 that can automatically sign messages based on on-chain conditions.

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. In order 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. NFT marketplaces such as OpenSea and Rarible, meanwhile, 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

Recently, many DeFi solutions have begun relying on  [intents](https://docs.cow.fi/cow-protocol/concepts/introduction/intents)  as a mechanism for providing users with better prices, MEV protection, advanced order types, and a whole host of other benefits.

CoW Protocol is a meta DEX 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 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 the time 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 autonomously place orders in even time intervals.

**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**: Some decentralized exchanges leveraging intents have begun offering “gasless trading,” a feature which 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**: On CoW Protocol, users can trade ETH natively, without having to use the ERC-20 “WETH” wrapped version. This is once again enabled by signed messages which specify 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 which allows users to use decentralized apps with just a traditional web2 email address. When using smart contract wallets, these services heavily rely on ERC-1271 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 it comes to 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)

An order that needs to be signed is created

![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 that provide much greater trading power for users.

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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EIP-1271 is an important upgrade to the Ethereum network that’s stirred up quite a buzz, but what exactly is it?


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 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. MEV relies on reordering transactions from the order in which they were submitted to a new, more profitable order.

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).

Now let’s take a look at how you can protect yourself from MEV.

## 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, 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. 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 send 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) 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 that finds the best prices for trades and provides comprehensive MEV protection. The protocol uses a unique trading mechanism that relies on batch auctions and  [intents](/learn/cow-protocol-glossary#:~:text=Intent%20to%20Trade)  to achieve the best outcomes for users.

![4-understanding-mev-protection.webp](https://celebrated-gift-f83e5c9419.media.strapiapp.com/4_understanding_mev_protection_cf34f8959e.webp)

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. 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. 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!

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MEV is a billion-dollar problem, but many Ethereum users still don’t know how to protect themselves.


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.