Uniswap v3 analysis
Clever innovations are ubiquitous in DeFi, but few have been as anticipated as is Uniswap’s version 3. Before I start I owe you a disclaimer - I do have a bit of a soft spot for the pink unicorn, since I believe the team at its core is in it for all the right reasons. However in this report I will stick to the objective description of what the new version brings and what they could, in my opinion, mean for the UNI token.
If we showed the current state of Uniswap to its founder Hayden Adams back in November 2018, when the project launched, he’d likely burst out laughing. As stated in his own words on Bankless podcast, the project started out as learning how to program smart contracts in Solidity and playing around with them. He was inspired by Vitalik’s blog post about automated market makers (AMMs). Fast forward less than 2 years since its creation and see that Uniswap alone is doing more volume than Coinbase.
Hayden attributes the success to two main factors. First is that the DeFi summer of 2020 gave us yield farming, from where we saw that the projects best positioned are the ones that are serving the long-tail of assets. Whereas DeFi projects like Compound or Maker rely on pooled risk, Uniswap’s is more on a per-token basis. Secondly, he attributes the success to users being able to provide “financial content”.
Think of how fast New York Times content comes out versus how fast youtube content comes out.
The Unicorn had competitors since before it began, but given the open-source nature of blockchain projects, it was not long, before somebody copied its code. And so, the nameless creator of Sushiswap did exactly that, forked the v2 code, added yield and overnight diverted a large chunk of liquidity to its new exchange. Despite Sushiswap’s rocky start, they became the main competitor at the end of last year and although Uniswap is arguably the most known DEX, it had to find other ways to stay relevant. Enter version 3.
Version 3
Concentrated liquidity
In v2, liquidity providers’ (LPs) funds were evenly distributed across all price levels. To simplify, they earn trading fees when the asset in question is traded, but since the distribution of the funds is even for everyone, that means that the only way to get better returns with providing liquidity, is that you provide more funds.
V3 is introducing concentrated liquidity, which now means LPs will decide for themselves at which price ranges they will concentrate their liquidity. In v2, your funds are spread evenly between 0 and infinity, earning you trading percentage, relative to the share of the pool you own. In v3, you will be able to concentrate this liquidity on any subset of prices. Your assets will be now evenly distributed only in your specified range, meaning your prediction of prices are correct, your capital’s efficiency is now increased by multiple x, depending on the width of your price range. On the flip side however, you will not be earning any fees if the price goes outside of your specified range.
Example: Alex and Bailey are both providing liquidity in the ETH/DAI pool in v2. For simplicity let’s say that ETH is $2000. They are each contributing 5 ETH and 10.000 DAI, meaning they each own 50% of the shared pool. For every trade they each earn the same amount of trading fees. In v3 however, Bailey decides to concentrate her liquidity in range from $1000 to $3000. This means that her ETH will get sold from current price to $3000 and her DAI will be spent from $1000 to current price. Alex decides he will spread his liquidity in the range from $1000 to $4000.
Since Bailey’s ETH liquidity is more concentrated, this means that it is only fair she earns higher portion of the fees generated. If the ETH is bought from the liquidity pool in the range from $2000 to $3000, Bailey will earn twice the fees Alex will, however in the range of $3000 to $4000 Alex will bag all the trading fees generated by the pool. Compared to v2, where all liquidity was always spread evenly across the entire price curve, this makes for a much better capital efficiency.
It is theoretically possible for the price to spike to the range without any provided liquidity, although this provides huge incentives for LPs, since they would earn all of the trading fees at that range. But, among many things, v3 brings the ability for LPs to provide liquidity across multiple price ranges, that can overlap. This, along with game theory should account for liquidity to be provided along all the price ranges.
Since LPs can now provide concentrated liquidity at multiple specified price ranges, they can do so-called range orders. They specify their preferred range and if the price enters that price range, their asset is sold, while earning swap fees in the process. This is profit-taking and buying-the-dip at a whole new level.
Flexible fees and fee switch
In v2, the trading fees of all pools were flat 0.3%. V3 will now offer three different fee tiers — 0.05%, 0.3% and 1%, according to the pair’s expected volatility. Although some liquidity fragmentation is possible, in rational environment pairs should converge to their expected fee tier.
- 0.05% … stable pairs such as DAI/USDC
- 0.30% … standard pairs such as ETH/DAI
- 1.00% … exotic pairs
A particularly exciting feature Uniswap (already) offers is the protocol fee switch, which allows for 0.05% of the trading fees (16.66% of LPs revenue) to be redirected according to the decisions made by governance via UNI token. Up until now, the switch has been turned off. In v3, the switch will be more flexible. They can again be turned on by governance on a per-pool basis and can range between 10% to 25%.
Advanced oracles
Oracles, which bring off-chain data on-chain are critical piece of the DeFi infrastructure. V2 introduced time-weighed-average-price (TWAP) oracles which store cumulative sums of Uniswap pair prices for every second. V3 introduces new version oracles, which can calculate any recent TWAP within the last 9 days in a single call, greatly reducing their price, by approximately 50%, relative to v2.
Licensing
One of the main drivers behind fast progress of blockchain in general is its open-source nature. But as we have seen in Sushiswap’s vampire attack this has not necessarily been always good.
V3 will launch under the Business Source License 1.1, which limits the productive and commercial use of the code for up to 2 years, after which it will revert to GPL license in perpetuity, meaning it will be allowed to copy the code for commercial and productive use afterwards. Although received with mixed feelings, I believe this will drive further progress in the ecosystem, since the team will now be able to focus more on the work itself, instead of playing chess with the competition. The code will still be fully visible on GitHub as it has been up until now.
Conclusion
I believe the following update will pave the way for Uniswap to become ever more popular among the users. Total DEX trading volume has been steadily rising, especially so since the DeFi summer last year. Uniswap’s dominance across the DEXes is also on the rise as can be seen on the chart below, provided by my favourite blockchain data webpage Dune Analytics.
Although average Joe is most interested in gas prices and will therefore often opt to use centralised exchanges to trade most tokens, the update is of immense importance nevertheless. It offers LPs much more capital efficiency and the current excitement about the update is in my opinion well justified. The increased capital efficiency unlocks new potential for services offering their customers passive income.
With Ethereum’s scalability solutions on the horizon, such as optimistic rollups and even more so ETH 2.0, it is important that the truly decentralised trading infrastructure is not just in place but battle-tested.
What could this mean for UNI token?
First of all, this is not financial advice. I could as easily be wrong as the next guy, I am simply thinking out loud and all comments are welcome.
I believe the update itself won’t have specific short-term effects on the UNI price. However this doesn’t mean I am not bullish on UNI. Looking at the Bitcoin dominance chart, it is telling us a major alt-season is likely just around the corner. If this is the case, most alt-coins will appreciate in value, compared to Bitcoin and UNI is no exception.
There were many great innovations in the blockchain industry, especially since the creation of Ethereum. Although most projects out there are either out-right scams or just without any fundamental value, those who provide something useful to users will remain relevant even after the end of hype cycle. Crypto markets are cyclical, by which I mean that when Bitcoin has had its run, the money usually flows into alt-coins and vice versa. This is the main reason, why I believe UNI token will do well in the short term. Looking at it long term, I see it doing well not because “everything will be pumping”, but because it is a project, that provides clear value to the system. And the v3 will just accentuate this.
I am investing in UNI token at this moment, because I believe it to be a good long term investment. However if the price pumps in the mean time, you can be sure I will be taking profits. Otherwise somebody else will.
Sources:
- Uniswap v3 blog post: https://uniswap.org/blog/uniswap-v3/
- Finematics: https://www.youtube.com/watch?v=Ehm-OYBmlPM
