Uniswap just released the V3 white paper and a guide to the upcoming release of UNISWAP Version 3. Previously we looked at investment strategies for Liquidity Provision on Uniswap V2 commenting on the boom in use of the platform which still holds around US$4.5Bn in LP at the time of writing this. In version two, liquidity providers (even smaller ones) have been able to make exceptional returns with a move to V3 likely, we ask if these returns will be higher, lower or stay the same?
- Summary TLDR;
- ‘Targeted LP’ = up to 4000X Capital Efficiency
- Tiered Fees — Payable in $UNI
- Range Orders — what’s that?
- Tokens no more — poole tokens become NFTs
- No Forking copy-cats (2 yrs at least)
- Expected LP behaviour (rebalancing around market price)
- Gas Usage
1. Summary TLDR;
Uniswap V3 introduces radical changes, bringing ‘targeted’ LP to mainstream DEFI, with tiered fees for each pool allowing higher risk to match with higher returns. Allows for ‘Range Orders’ — making it easier to set a limit for an ‘orderly’ big swap or perhaps an exit strategy.
The software will be open-source, but not freely available for two years preventing copy-cat solutions and potentially scams. The ‘focused LP’ is expected to mirror traditional order-book behaviour clustering around current market price and users will adjust according to the changes in price. Gas usage is expected to be lower than in V2 and will also use some of the sharding / roll up technology being rolled out in ETH 2.0. Specifically ‘optimistic’ roll-ups. The main date is May 5, 2021 on the Ethereum Mainnet with L2 on Optimism shortly after.
2. ‘Targeted LP’ and up to 4000x capital efficiency
The AMM method used in Uniswap V2 is the ‘constant product model’ which can create significant ‘impermanent loss’ for the Liquidity Providers where there is a lack of correlation between the two tokens for which you are providing liquidity;
The net effect of this is that technically LPs are providing liquidity across the entire range of possible prices between the two assets. This is because when a ‘SWAP’ is made using the pool it is forced to ‘rebalance’ and if there is a price difference between when the SWAP takes place and the rebalancing then the LP will provide the difference (their share) required to rebalance the pool. If we pause for a second and think about that, in a ‘run’ or big, rapid, consistent change in the price between the two assets in one direction the LP providers are losing out every time — as can be seen from the chart above. In addition, they are also effectively ‘making a market’ for all possible prices — offering liquidity for everything, including one of the tokens going to zero.
This is very ‘capital inefficient’ since ALL of the money you are providing is tied up offering your agreement to any price , rather than the most likely prices which will be around the current market price.
To improve this, V3 allows the setting of ‘ranges’ for which the LP is providing liquidity. This has two outcomes: the first is that the pool can provide much more liquidity around the actual likely prices which traders want to trade, the second is that the LP will ONLY earn fees if they are providing liquidity for the prices being offered. This is where the ‘4000X’ comes in, based on the narrowest of ‘liquidity ranges’ and the specification of allowable minimum differences in price, for example this is for $1000 in LP;
This is providing liquidity on ETH / USD(say) only where the price of the SWAP is between $1818 and $1820. Moving this down to a $0.01 band takes the ‘capital multiplier’ up to over 7000 but initially this will be limited to 4000 by restricting price ranges to a minimum of 0.1%.
Outside of this range your LP capital is effectively ‘cashed out’ into whichever side of the LP pair lost (relative to your range set). At this point your capital is sleeping and earning zero fees.
There are some ‘unknowns’ around the gas cost (see below) of setting and changing this range and the frequency at which this can be done. One provider can also provide liquidity around multiple non-contiguous ranges meaning that you could have gaps in the ranges if you wanted to ‘machine-gun’ a specific range with highly concentrated liquidity if you perhaps spot small ranges with limited liquidity being provided and wanted to get the lion’s share of that.
3. Tiered Fees — payable in $UNI
One of the features/perceived weaknesses of Uniswap V2 was that the fees were high at 0.3% for all pools. It was also noted in our V2 strategy article that because the fees were earned in pool tokens they were automatically re-invested in your LP position. This allowed a long term strategy which meant that you would have ‘impermanent loss’ but this would be compensated for by the fees and over time you could be ahead of the ‘just HODL’ . We provide a free calculator for this here which includes an example of this for WBTC/ETH since 20th May 2020 showing a 15% gain on just holding an equal balance of the two tokens which looks like this;
This however meant that your fees were never really earned and were just stored in pool tokens which were completely exposed to fluctuations in the asset prices for the pair. On the one hand this allowed ‘set and forget’ accumulation and re-investment of gains. On the other, this meant that one day you could have made 50% fees and overnight ( in a 24/7/365 market!) one of the tokens might go to zero and your store of the ‘winning’ token would be drained to zero as you accumulated 17 million of the losing token like here. In version 3, the fees are all earned in UNI tokens which have a healthy trading volume and liquidity but this does add a new nuance to the fees earned and effectively removes the possibility of running a ‘US$ deposit account’ type pair with low risk since the fees (pseudo-interest) will be paid in a volatile, non-stable asset. An additional consideration is that all of these fees earned will be newly-minted UNIs inflating the currency.
Another feature/disadvantage of this is that for pairs including stable/stable pairs, with no significant exposure to price volatility it was possible to earn an equivalent annual percentage rate of up to 19% on some pairs as discussed here. This sounded great and indeed has been for many liquidity providers getting significant risk-weighted return from this outperforming even the wildest bonds available. The other side of this coin was that this was being paid by ‘swappers’ using the UNISWAP exchange at a rate of 0.3% on every trade, which did not really reflect the risk.
In Version 3 of UNiswap there are (initially) three fee tiers 0.05%, 0.3% and 1%. It appears reasonable to assume that the over time fees will match the risk of the pair for which liquidity is being provided although since this is set by the person creating the initial pool, there remains some possibility for taking advantage of providers who don’t check this before entering a pool.
This should be widely seen as an improvement over a flat fee as it will better align reward and risk in the market and might even set a trend with other exchanges. It should also be noted that this introduces a Protocol Governance Fee which can be seen as a revenue model for the protocol which allows for the funding of maintenance and ongoing development of the Uniswap protocol. Based on the behaviour of the team to date, and the very low values specified it is likely to be widely welcomed as it should provide sustainability for the protocol.
4. Range Orders — what’s that?
A feature new to UNISWAP V3 is that of Range Orders. This allows ‘single-sided’ liquidity positions where just one token can be added to a pool and liquidity added for a very small range, probably far from the current market price, meaning that if this price is crossed then the LP’s single asset provides liquidity and is converted to the other side of the pair. This could be used with the following types of strategy (using prices from march 2021) ;
- Swap my ETH for USDT if the ETH price hits US$2,000 — (cashing out and taking profit)
- Swap my BTC for USDC if the BTC price hits US$49,000 — (getting into a safe-harbour in a dip)
- Swap my $1k USDC for BTC if it drops to US$49,999 — (buying the dip)
- Swap my $10 USDC for $NEWTOKEN if it hits $0.5 — (underwriting a launch at a specific price)
These could be used for protection against ‘black-swan’ events by choosing very unlikely prices and also to make huge gains in this event as being the only provider of liquidity for a given price.
One notable wrinkle in the finality of any of these conditions being met and the trade being executed is that if the token moves in the other direction again and you are still providing liquidity and have not withdrawn your position you will revert back to the other asset.
5. Tokens no more — pool tokens become NFTs
One of the features and perhaps weaknesses of V2 was that participation in the Pool required converting your assets into ‘pool tokens’ meaning that you did not infact own any of the two tokens but instead you had an effective share of the pool. These were ‘fungible’ meaning completely interchangeable one for the other and indistinguishable. Here is an example of one of these pools here showing all of the providers in the Uniswap USDC/ETH pool. This allowed for a lot of incentivisation for example the so-called staking of these, which was effectively handing them over to someone else in order to perhaps receive a related or unrelated token as in yield-farming. Many platforms offered this as a way to launch and grow their own token as well as widely distributing the supply.
With the introduction of V3 and ranged liquidity, every provider’s exposure and participation is different and thus not interchangeable and the concept of pool tokens would not make sense.
The Uniswap team believes that fungibility may be possible in the future through peripheral contracts and/or partner protocols. This could (for example) be a way of grouping together investors and allowing them to follow a strategy in unison allowing passive participation at an individual level while the ranges and prices are moved by a protocol or algo-investor.
6. No Forking Copy-Cats! ( for 2 years at least)
One of the highlights and perhaps lowlights of 2020 was that the UNISWAP code was entirely open source and freely available for copy. This allowed many many projects to simply copy the code and put their own pretty front-end on it and perhaps launch their own token as a farming reward for use of the platform. In many cases this helped innovate and develop other types of DEFI exchange such as CURVE and BAL who provided a stable coin flattened-curve and a non 50/50 variation in particular. It also led to outrageous yield incentives and a massive ‘rug-pull’ as a founder of one of the copycat platforms sold a huge number of tokens very quickly and disappeared.
This did not directly impact UNISWAP but must have prompted a re-think on going open source immediately meaning that in Version 3 the code will be released under license which reverts to GPL2.0 after two years. This should be welcomed as it will allow the project team to permit forking for worthy projects and teams rather than allowing completely open access.
7. Expected LP behaviour (rebalancing around the market price)
As a result of the incentive to provide focussed liquidity (4000X!!) it can be rationally expected that most users will try to strike a balance between magnifying their returns and staying ‘in the fees’. Given the volatility of crypto prices (8% in 24hrs as I write this) it is likely that depending on the cost of changing the liquidity provision range or ranges (see gas below) this will become a game of whack-a-mole as providers try to react to movements in prices to game the best rewards.
It could be argued that this will lead to the creation of algorithmic, automated adjustment for the biggest pools run by the biggest providers for whom gas is relatively trivial and an arms race as the equivalent of high frequency trading drives all of the fees to the biggest and best-armed liquidity providers.
In the spirit of DEFI, we do hope that there is some (as yet unidentified) natural ECOsystem control on this and that at least rudimentary algorithms or pooling can become available to allow the smaller liquidity provider to still make something from the market but it really does look like the days of ‘set and forget LP provision’ which gave everyone the same share are over unless you want to just go with very wide range and hope to get something.
You could of course choose to stay on the old V2 model but who will trade there? The fees will be higher for less risky assets and liquidity will be lower?
Novum are already working on a pooling / algo strategy to help the smallest investors use V3 effectively. Watch this space for updates.
8. Gas Usage
One of the complaints against DEFI and specifically UNISWAP V2 was the high cost of ‘gas’, the ethereum fee for processing transactions on the blockchain. This effectively meant as discussed before that the cost of swapping, adding or removing liquidity became prohibitive for the smaller providers when network congestion led to higher gas prices. V3 looks to resolve this by using some of the technology from ETH2.0 which moves to proof of stake and is believed to reduce gas fees significantly. This will be done by using ‘Optimistic rollups’ which can be researched further here.
Although the team believes that V3 will have limited effect on gas efficiency, a lot will depend on the gas cost of changing the ranges for which liquidity is being provided as it appears likely that most users will want to adjust their positions regularly to maintain a healthy use of their capital.
We have looked some of the gas used in the test snapshots and some of the values look lower than in V2 but also some higher viz.,
This is too simplistic however as there are many dependencies and factors such as the tokens involved and the sample size is too small to draw any conclusions.
In general, our prediction is that there will now be a much bigger difference in LP gas costs (higher) compared with traders’ gas costs (lower) but this (combined with more accurate fees) will benefit the platform holistically as more traders will come (volume) and trade and more fees will be made for LPs.
The hope is that with the ‘rollups’ a much smaller percentage of total transactions will require checking (meaning processing and mining on ETH L1) but as this is a new feature it is not yet clear what magnitude this impact is likely to have. Less than 100% will be an improvement in any case!
So there you have it. Uniswap V3 will bring increased liquidity, allow the implementation of sophisticated LP strategies and potentially magnify both returns and capital efficiency. It will help align risk and reward and make trading cheaper. This should in theory lead to increased volume on the platform.
Subscribers to our Momentum Pairs service will receive some of the first data on Uniswap V3 as we have already begun looking at the source code and are working on how to make smarter decisions once V3 goes live.
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The ‘defi-calculator’, including the ‘top ten’ constitute entirely estimated historical returns which provide no guarantee, promise or calculation of potential future returns or losses. In addition, all of the assets displayed and shown on the website are highly volatile and risky.
Credit: Written by David Henderson for Novum Insights