Analyzing the Development Trends of Uniswap V3: Liquidity Continues to Grow, Active Market Making Strategies Emerge Continuously

This article is from PANews, original title: "Understanding the Development Trends of Uniswap V3: Can High Capital Utilization and Low Fees Disrupt Centralized Exchanges?"

Uniswap has continued to surprise us from V1 to the current V3. The updates in Uniswap V3 include granular control of aggregated liquidity, range orders, multi-tiered fees, and advanced oracles. Uniswap V3 gives users more autonomy, allowing them to customize their liquidity ranges, which enables the functions of liquidity aggregation, range orders, and limit orders.

In Uniswap V2, all liquidity is distributed according to the constant product curve k=x*y within the range of 0 to positive infinity. However, prices at both ends of the range are difficult to reach, resulting in a large amount of idle capital. For certain specific trading pairs, price fluctuations may be limited to a very small range, and if funds are still allocated across the entire range, it leads to significant waste. Many projects have optimized this basis and achieved success, such as Curve, which chose to optimize the joint curve to concentrate liquidity within a specific range for trading similar assets like stablecoins.

In this upgrade of Uniswap V3, the concept of "Tick" has been introduced, making Uniswap's trading increasingly resemble traditional order book models.

Tick is not unique to Uniswap; in traditional futures trading, Tick refers to the minimum fluctuation of contract prices. Uniswap V3 allows liquidity providers (LPs) to customize their liquidity ranges, where the minimum and maximum prices set by LPs represent the minimum and maximum values of Tick. The liquidity of LPs is distributed across each Tick within the range, and this data is reflected in the NFTs generated after providing liquidity. Trading fees are calculated separately within each Tick and distributed to users based on their liquidity share in that Tick.

When the market price fluctuates due to a trade, it may cross several Ticks, and once the original liquidity is exhausted, it will turn into liquidity in the opposite direction. For example, in the USDT/WETH trading pair with a 0.3% fee, the corresponding Ticks for ETH prices in the range of 1204.8 to 3904.9 are -205380 to -193620. When the price falls below the price corresponding to Tick -205380, the liquidity of buy orders above that Tick will turn into sell order liquidity.

By customizing liquidity ranges and fees, Uniswap V3 will significantly improve capital utilization.

Higher Capital Utilization

Comparing the data of Uniswap V3 and Uniswap V2, Uniswap V3 has captured more trading volume with lower liquidity than V2. For example, on May 28, the locked amount in Uniswap V3 was only $1.58 billion, but the trading volume in the past 24 hours was $923 million. In contrast, Uniswap V2 had a locked amount of $5.72 billion, with a trading volume of only $741 million in the past 24 hours.

Similarly, when compared to other exchanges, Uniswap V3's data is also impressive.

SushiSwap on Ethereum has a locked amount of $3.32 billion and a 24-hour trading volume of $142 million.

PancakeSwap on BSC has a locked amount of $8.2 billion and a 24-hour trading volume of $920 million.

QuickSwap on Polygon has a locked amount of $940 million and a 24-hour trading volume of $229 million.

From the perspective of capital utilization, Uniswap V3 undoubtedly becomes the best decentralized exchange. Even from the perspective of trading volume, Uniswap V3, with its relatively low locked amount, has become the DEX with the highest trading volume currently.

Trading of Similar Assets

In the trading of similar assets, Curve has firmly occupied the main market among decentralized exchanges due to its low slippage and low fees (0.04%). Other decentralized exchanges typically require a 0.3% fee, which is not competitive for trading larger amounts of stablecoins. In the centralized exchange sector, Binance tries to expand the application of BUSD by waiving fees for trading pairs between its own BUSD and other stablecoins.

After the launch of Uniswap V3, users can set the liquidity for trading pairs of stablecoins with low volatility within a very small range. For example, in the USDC/USDT trading pair, liquidity can be limited to a narrow range of 0.994 to 1.005. Through extremely high capital utilization within this small range, LPs can earn profits and have a trading experience with stablecoins comparable to Curve.

Comparing a trade of 100,000 USDT for USDC, Uniswap can yield 100,006 USDC, while Curve can yield 100,018 USDC. Considering the difference in gas fees for both, Uniswap V3 may provide a better experience.

The yields on stablecoins on decentralized platforms have also decreased with the influx of funds and the maturation of platforms. For example, on May 28, the yield in Curve's Y pool was the base APY of 2.18% plus CRV rewards of 0.88% to 2.21%. If CRV tokens are not staked, the comprehensive annualized yield of the Y pool is only 3.07%.

Comparing the three trading pairs of stablecoins with a 0.05% fee in Uniswap V3—USDC/USDT, DAI/USDC, DAI/USDT—based on the TVL and 24-hour trading volume on May 28, the calculated APYs without token incentives are 8.7%, 5.7%, and 12.1%, respectively, exceeding the yields of most stablecoin pools in Curve. Therefore, currently for LPs, providing liquidity for stablecoin trading pairs in Uniswap V3 can yield higher returns than Curve.

Low Fee Cross-Asset Trading

After the success of Uniswap's AMM mechanism, various DEXs imitating Uniswap have set trading fees at the same 0.3% as Uniswap, which makes on-chain trading friction much greater than that of centralized exchanges. For example, in Binance, without invitation rebates or other fee reductions, the trading fee for cryptocurrency trading is only 0.1%, and if using BNB for deduction, the fee can be reduced to 0.075%.

Uniswap V3 allows for customizable fee rates, currently offering three tiers: 0.05%, 0.3%, and 1%. If lower fees lead to larger trading volumes, ultimately the APY for LPs may not be lower than other tiers, which could attract LPs to choose the 0.05% fee rate.

From the chart below, liquidity for ETH/stablecoin trading pairs is still concentrated in the 0.3% fee trading pairs. In trading pairs with a 0.05% fee, the yields for ETH/USDC and ETH/USDT are lower than most other trading pairs, while the yield for ETH/DAI is much higher than other trading pairs. In cases of insufficient liquidity, daily fee earnings can fluctuate significantly, and overall, the yield for ETH/stablecoin trading pairs with a 0.05% fee may be slightly lower than that of the 0.3% tier.

According to Uniswap founder Hayden Adams at the Consensus 2021 conference, Uniswap is providing funding through grants for the community to build liquidity mining smart contracts, allowing any project that wants to incentivize liquidity to use the contract. If community governance approves, UNI may launch a liquidity mining program.

If liquidity mining rewards can be applied to the major trading pairs with the most needed incentives at the 0.05% fee tier, it could significantly reduce trading friction on Uniswap compared to centralized exchanges, potentially disrupting the existing decentralized and centralized exchanges, making Uniswap, as reported by the Wall Street Journal, the biggest competitor to Coinbase.

Future Trends

In less than a month since the launch of Uniswap V3, its daily trading volume has almost surpassed all decentralized exchanges. From this, we can also see some future trends.

• The liquidity of Uniswap V3 will continue to grow. After the significant drop on May 19, the TVL of decentralized platforms like Uniswap V2 was greatly affected, and now the liquidity of Uniswap V2 is only about half of its peak. In contrast, the liquidity of Uniswap V3 has continued to grow after a brief decline.
• The growth rate of trading volume may not keep up with the growth of liquidity. In recent days, while liquidity has increased, the trading volume of Uniswap V3 has continued to decline due to overall market inactivity.
• The attractiveness of trading fees for ordinary users will continue to decrease, with the risk/reward ratio rising. Without sufficiently excellent strategies, the risk of providing liquidity in the small ranges on Uniswap is extremely high. Although Uniswap can significantly enhance capital efficiency, impermanent loss also increases proportionally. According to simulations from htdefi-lab.xyz/, if liquidity is concentrated between half to twice the market price, the capital utilization rate is 3.41 times the original, but impermanent loss will also increase proportionally during market fluctuations. Based on actual experience, the average liquidity of the ETH/USDT trading pair at the current 0.3% fee tier is much more concentrated than this. In the current market with significant price fluctuations, aggregating liquidity may result in impermanent losses that are insufficient to offset fee earnings.

• Liquidity will continue to cluster near market prices and will change with market price fluctuations. Taking the current best liquidity trading pair ETH/USDC as an example, with ETH priced at 2505 USDC, liquidity is mostly distributed in the range of $2000 to $3400. The chart below also shows that there are large orders providing liquidity in the range of $2560 to $2600. When the price breaks above this range, the user's entire ETH will be sold, and the provision of liquidity and order placement will no longer be inseparable.

• Uniswap V3 will benefit from the development of Layer 2. The market-making strategies of Uniswap V3 will be more flexible on Layer 2, reducing the impact of gas fees. Uniswap has already maintained a good cooperative relationship with Optimism, but due to the delay of the Optimism mainnet, Uniswap V3 has not been able to launch on Layer 2. Another Layer 2 star project, Arbitrum, is about to launch, which may gain a first-mover advantage. Uniswap has conducted a vote on Snapshot to prepare for deploying Uniswap V3 on Arbitrum, which has passed with 100% support.
• New professional market-making institutions and active market-making strategies based on Uniswap V3 will continue to emerge, potentially leading to excellent market-making gun pools. Currently, several outstanding projects such as Lixir, Charm Alpha Vault, Visor, and Method Finance have emerged, and a brief introduction will follow.

Lixir: A market-making strategy provider for Uniswap V3 that allows market-making funds to remain concentrated while ensuring that there is ample liquidity near the market price as it moves.

Charm Alpha Vault: Helps liquidity achieve capital rebalancing. For example, if the initial value of ETH and USDC is 1:1, when the market price drops and the proportion of ETH increases, the Alpha Vault will first withdraw liquidity and re-provide liquidity at a 1:1 ratio of ETH and USDC based on available funds, and only provide liquidity with ETH at a higher price range.

Visor: An active liquidity management tool. It provides self-custody mining, reward fee accumulation, and time-locking features, including three components: Visor Vault, Hypervisor, and Supervisor. The Visor gun pool can lock LP NFTs to prevent project parties from withdrawing funds. Hypervisor can earn liquidity rewards based on predetermined trading ranges. Supervisor can update the preset parameters of Hypervisor, manage assets, and execute strategies.

Method Finance: Similar to Visor, it allows users to self-custody Uniswap LP NFTs in the form of NFT vaults.

Conclusion

Uniswap V3 significantly enhances capital utilization, allowing it to achieve greater trading volume with only 27.6% of the TVL of Uniswap V2. As professional market-making teams and active market-making protocols mature, Uniswap V3 may bring substantial profits to professional institutions, but it will become increasingly difficult for ordinary retail investors to participate, as the risks of impermanent loss are hard for them to control.

Overall, Uniswap V3 is an update that benefits most people, providing traders with better liquidity, while professional market makers can leverage their technical and capital advantages to achieve higher fee rates than centralized exchanges. Early-stage projects can also reduce the impact of initial price fluctuations by customizing fee rates and liquidity ranges.

If Uniswap V3 can push the 0.05% fee rate into the mainstream, it may truly disrupt the existing cryptocurrency trading system. From current data, the LPs' earnings for ETH/stablecoin trading pairs at the 0.05% fee tier are not significantly different from those at the 0.3% tier. If compensation can be obtained from Uniswap V3's liquidity mining, it may increase the market share of 0.05% fee trading.