Senior Market Maker Evaluation of Uniswap V3: Core Advantage Lies in Providing Composable Strategies
The development of DeFi needs to draw on the composability advantages of traditional finance to attract more participants, which is exactly what Uniswap V3 is attempting to do.This article was published on DeepGo medium, author: Byte and Benedict Zhou
Uniswap V3 introduces new features: whether it's the new AMM mechanism with "price scaling" or the customizable "elastic fees," both provide liquidity providers with more strategic flexibility. As a quantitative researcher immersed in crypto asset market-making strategies for many years, I discovered a new era of DeFi amidst the ordinariness of Uniswap V3.
Abstract
From a micro perspective, especially for traditional traders, the granular concept of V3 seems unremarkable, and its trading method is closer to centralized exchanges. However, in the long run, V3 brings more customization and combinability for investors, greatly expanding the boundaries of DeFi investment strategies.
The significance of V3 lies in supplying more customizable strategies to accommodate more investment needs, while the NFT-ized LP Token becomes a value unit that matches small investment needs with professional team suppliers, achieving the transmission of value on the internet, which is the greatest innovation in current DeFi.
There exists an impossible triangle dilemma in investment regarding returns, risks, and scale. V3 improves capital efficiency to increase returns, but it also amplifies risks, making it particularly crucial to provide external feeding data for Uniswap V3 to achieve risk pricing.
With global regulations tightening and CEX facing immense pressure, this is a critical juncture for DEX platforms to seize the market. DeFi achieving value transmission on decentralized blockchains is an inevitable trend, but it also requires the right timing, location, and people to truly explode. The V3 ecosystem is currently in a brewing phase, and more innovative projects compatible with it, such as new liquidity machine gun pools and customized strategy solutions, will emerge soon.
Imagination of NFT-ized LP Token
In Uniswap V2, after users add liquidity, Uniswap returns an ERC20 token to the user, which is the LP Token. This type of LP Token represents the liquidity provider's ownership of the liquidity they provide. When users want to redeem their liquidity, they only need to destroy their LP Tokens to obtain a share of the corresponding tokens in the liquidity pool.
Since Uniswap V2 adopts an overall liquidity pool model, LP Tokens are standard ERC20 tokens. However, in V3, each LP creates liquidity based on different price ranges, so the provided liquidity uses ERC721 tokens as certificates, and Uniswap will issue customized NFT cards for each liquidity provider.
This simple NFT card represents a value unit, carrying the liquidity provider's time cost, risk cost, and strategy value. In the development of the internet, the standardization of value units laid the foundation for various internet platforms, such as Amazon's product links and Instagram's images. Today, the blockchain world is like the internet of 2003-2004, on the eve of an explosion, and the improvement of value units will allow users to standardize and grow rapidly, ultimately forming network scale effects.
The NFT-ization of LP Tokens is essentially asset securitization. As a financial tool, the original intention of asset securitization is to improve resource allocation and enhance the efficiency of capital operation. In traditional finance, the opacity of asset securitization has led to risks being out of control, which has been criticized. However, in a decentralized world, the trustworthy value of blockchain significantly alleviates such concerns.
Decentralized Liquidity Machine Gun Pools
Ordinary users cannot quickly respond under the liquidity scheme of Uniswap V3, making it even harder to grasp reasonable price ranges, with evident oligopoly effects, while professional quantitative market-making teams have advantages. The granularity of Uniswap V3 has derived more customized strategies, thus creating a market for liquidity machine gun pools.
In the short term, decentralized liquidity machine gun pool projects hold immense value for investment demanders, while in the long term, they provide positive feedback incentives for asset suppliers, with the core lying in the data algorithms between supply and demand. Data feedback helps form a healthy curation market, where quality and stable strategies are sorted and filtered, while high-risk low-return strategies are quickly eliminated, thus achieving efficient resource allocation.
Under the synergistic effect of innovative machine gun pool projects, Uniswap V3 will construct a more stable derivatives system, buffering the risk of malicious dumping by project parties and further safeguarding investors' interests. The underlying assets corresponding to LP Tokens are a combination of base tokens and project tokens. This means that in the case of severe market fluctuations, the rate of change in the value of the collateral will be reduced, thus achieving liquidation buffering.
Impossible Triangle Dilemma
Uniswap V3 introduces mechanisms such as "concentrated liquidity," "fee customization," "range orders," and "non-homogeneous positions," all aimed at improving capital efficiency. While helping liquidity providers to avoid impermanent loss as much as possible and create higher returns, it inevitably increases risks. In the classic investment trading rule, increasing returns, reducing risks, and expanding scale is an impossible triangle dilemma, making it difficult to achieve all three simultaneously.
In Uniswap V3, the yield for liquidity providers has significantly increased, but the risk of capital has also notably risen. Especially in extreme market conditions, when the price of a certain asset in a trading pair skyrockets or plummets, exceeding the price range set by the liquidity provider, the liquidity within that range will be drained by market arbitrageurs, making risk control a challenge for liquidity providers.
When the risks of Uniswap V3 cannot be effectively controlled based on its own mechanisms, liquidity providers can only seek external risk data feeding. At this point, NFT-ized LP Tokens, as a bridging value unit to the outside world of DEX, will play an important role.
LP Tokens, as an innovative derivative, also need to be utilized efficiently. The DeFi space is not short of liquidity providers who, after staking trading pairs in liquidity pools, can only obtain one-sided returns from liquidity mining, and their capital has not been fully utilized. As a certificate of capital rights, LP Tokens can not only circulate in the market but also be staked to achieve higher capital utilization rates.
Uniswap V3 + CDO Model
CDO stands for Collateralized DEX Offering, developed by the DeepGo team. Users achieve continuous financing through staking risk-graded collateral. After market makers provide initial liquidity in Uniswap V3, they lock LP Tokens as collateral in the CDO protocol to continuously obtain liquidity buy orders.
When Uniswap users provide liquidity in V3 and set a larger range, the value fluctuation of the liquidity target based on the base currency is relatively small. The following diagram simulates the curve of the overall value of the target changing with token prices after users stake the same value in V2 and V3 versions. It is evident that the value curve in the V3 version is smoother.
If CDO suppliers stake LP Tokens from the Uniswap V3 version, the collateral's risk resistance will significantly improve under extreme market conditions, which will also make the boosting pool system more robust: providing reasonable risk warnings when project tokens rise sharply; and ensuring risk buffering when tokens plummet. The combination of Uniswap V3 and CDO ultimately allows quality assets to appreciate over the long term, while poor assets gradually decline and are eliminated.
More Accurate Risk Pricing
In the CDO model, to achieve more accurate risk pricing, it is necessary to grade risks to form fixed-income graded funds. In addition to the project initiator (IP), two main roles need to participate, divided into important participants (GP) and fixed-income providers (LP). Both roles will provide continuous capital input for the project, with GP as the direct investor of the project, converting all principal into project tokens, while LP's funds will be used as leverage for GP, helping the project achieve greater value growth.
In the CDO model, IPs are allowed to stake high-quality assets (LP Tokens from Uniswap V3), which adds a layer of protection for GPs and encourages a large influx of GP funds. Each influx of GP funds will inject capital into the Vault, used to store LP's risk reserves and profits. As the capital volume of the Vault increases, LP's willingness to invest is gradually amplified.
As follows:
LP~w~ ∝ Vault ∝ IP~col~ * GP~turnover~ * IP~ltv~
GP~turnover~ ∝ GP~w~
Where:
IP~col~ is the collateral of the IP
IP~ltv~ is the current staking ratio of the IP
GP~turnover~ is the turnover rate of the GP
GP~w~ is the investment willingness of the GP
LP~w~ is the investment willingness of the LP
Vault is the reserve fund
Thus, through effective signal transmission, the lower volatility of the IP's staked assets effectively drives the LP's capital capacity, with LP funds being the most crucial part of the market feedback loop, playing a positive multiplier effect.
If the project is a poor asset, GP participants, having converted all their base currency into project tokens, will experience a volatility of the GP's leveraged assets far exceeding that of the IP's collateral. At this point, GPs may be the first to be liquidated due to the decline in project asset prices. The remaining GPs are more willing to enjoy the collateral after the IP is liquidated, thus reducing turnover rates. This directly leads to a shrinkage of the Vault's increment, significantly lowering LP's investment willingness, thereby gradually eliminating poor projects.
LP~w~ ∝ IP~col~ * GP~turnover~
GP~turnover~ ↓ ⇒ LP~w~ ↓
Such a transmission mechanism can not only enable the CDO model to operate healthily, becoming a cleaner of poor assets, but also convey a large amount of effective market information, serving as external feeding data for risk pricing in Uniswap V3, providing decision feedback for investors and liquidity providers.
Conclusion
After the upgrade, Uniswap V3 seems ordinary, but it provides many innovative foundations for DeFi applications. Now that CEX faces internal and external troubles, it is a critical moment for DEX to rise. How can DeFi lead the next bull market? The core lies in absorbing the combinability advantages of traditional finance, creating more user-friendly and efficient strategy products, and realizing inclusive finance, thereby attracting more participants.
In my previous view, Uniswap did not originally have a moat, but with the emergence of V3, it offers more combinable solutions. In the world of open finance, the alpha returns brought by V3 will give rise to numerous innovative products, thus forming a true head effect, which is its important strategic layout. However, DeFi is inclusive finance, not an oligopoly game. How can small investors enjoy the alpha returns that only scientists or whales can obtain through certain protocols? This is the direction we are currently focusing on exploring.
