In-depth Analysis of the Innovations and Disruptions of Uniswap V4

Author: Lian Zhu, Aperture Finance

Japanese designer Kenya Hara once interpreted his design philosophy as follows: "In this world, there are only two things we use, one is a stick, and the other is a bowl." The "bowl" generally refers to all carriers that hold other things, such as bookshelves and refrigerators; while the "stick" is a tool that acts on other things, such as a screwdriver or a lever.

If Uniswap V3 is more like a bowl, carrying liquidity to empower DeFi, then V4 is more like a stick, driving industry transformation through functionality and overturning the existing situation in DeFi. As a DeFi practitioner, based on current information, it is not difficult to imagine that a storm is brewing regarding the product form and user experience of Uniswap. Six months after V4 goes live, it will surely stir up a bloodbath.

Looking back at the history of this "unicorn," Uniswap V1 (the first version) was born in November 2018, emerging as the first decentralized exchange on Ethereum, providing exchanges between ERC-20 tokens and ETH. Projects that emerged around the same time, either by borrowing or integrating, include SushiSwap, 1inch, Curve Finance, Balancer, and Synthetix. Uniswap V2 (the second version) was launched in May 2020, further providing swaps between ERC-20 tokens. With its liquidity empowerment, projects that arose during the same period include Yearn.finance, AAVE, Compound, and Chainlink. Uniswap V3 (the third version) went live in May 2021, introducing concentrated liquidity, with projects that became famous for providing position management, such as Visor Finance (later merged into Gamma) and Instadapp, among others.

From V1 to V3, there were technological breakthroughs, but essentially they were a continuation, with the project team relying on Uniswap to build a vast ecosystem. However, from V3 to V4, the technological breakthrough is no longer from zero to one, but rather a market disruption. Below is a brief analysis from the perspectives of liquidity and product form.

Uniswap V3 integrates liquidity pools, meaning that liquidity for a specific trading pair is relatively concentrated. The liquidity pool in Uni V3 is defined by two parameters: the "trading pair" and the fee rate. For example, looking at ETH-USDC, there are 4 liquidity pools in V3, each corresponding to 4 different fee levels. These 4 pools provide liquidity for all trades between ETH and USDC. However, with Uniswap V4, this situation changes. Its disruption and innovation lie in the fact that anyone can customize pools and implement various additional functions through "hooks." Therefore, for the ETH-USDC trading pair, in theory, there can be countless pools, such as market maker Zhang San providing an "ETH-USDC-Zhang San pool," and market maker Li Si providing an "ETH-USDC-Li Si pool." The Zhang San pool has its own functions, while the Li Si pool has its own selling points. There can be countless pools providing liquidity for trades between ETH and USDC, and the fragmentation of liquidity is evident.

Taking hot pot as an example, the liquidity pool of Uniswap V3 is like a large pot where everyone cooks the same flavor, with no need to choose and no way to choose, although the pot is big enough and the water is deep. Here, the water represents the liquidity of funds. Uniswap V4 allows everyone to customize small pots, providing various special flavors to attract diners. The "flavors" here are analogous to the functions added through hooks, such as on-chain limit orders and automatic reinvestment. With a variety of flavors, everyone can choose according to their preferences. However, as the pots are divided more, the water remains the same, so some small pots may not have enough depth to cook the meat properly.

Uniswap V4 offers unprecedented openness, allowing for a flourishing of diversity while opening a Pandora's box that may lead to consequences including:

1) Fragmentation of liquidity. From the perspective of the existing market, there is only so much liquidity available; with more pools, the average liquidity decreases. If one pool has more liquidity, another pool will have less. In extreme cases, if liquidity is evenly distributed across countless small pools, a large transaction may not be completed within a single pool. Therefore, in an environment with multiple liquidity pools, the role of liquidity aggregators like 0x or 1inch will be significantly highlighted.

2) Lowering the barriers for competitors to enter the market. Some complex rebalancing functions (such as triggering rebalancing based on market conditions) would require off-chain infrastructure to achieve real-time pricing and send transactions on-chain in V3. Common methods include using Gelato services or building off-chain infrastructure (Aperture Finance adopts the latter approach). In Uni V4, with hooks, project teams can natively implement condition-triggered rebalancing functions without relying on third parties or building additional infrastructure, greatly simplifying development and reducing operational costs.

3) Liquidity management projects or market makers may adopt more aggressive incentive measures to compete. The functions that can be added through hooks in Uniswap V4 are limitless, including custom profit distribution or subsidies. If a bank offers currency exchange services that not only allow users to exchange at ideal rates but also waive fees and even provide subsidies, that bank is sure to become popular, while other banks may have to follow suit. Project teams can choose to subsidize various fees or even pay users to attract them to join their pools. This could lead to liquidity being eroded and differentiated among project teams, with the degree of internal competition being significant.

4) The process of survival of the fittest will be accelerated. The liquidity that originally existed in Uniswap V2 or V3 may gradually withdraw and shift to V4. DeFi projects relying on V2 or V3 may struggle due to the loss of liquidity, while competition for liquidity pools in V4 will continue to intensify (as mentioned above), accelerating the downfall of project teams and ultimately leading to a monopoly.

5) A test of brand recognition. From the user experience perspective, the previous currency exchange experience involved directly selecting the currency and amount, but after V4, users also need to choose a pool. The user experience of selecting liquidity pools is currently unknown, but once it involves choosing between similar pools, brand recognition becomes particularly important, in addition to functionality and benefits. This poses a challenge for project teams on how to maintain their brand image and stand out among numerous competitors.

A storm is brewing, and project teams in the DeFi-related track need to plan ahead. With six months to go, whether Uniswap V4 is a "bowl" or a "stick," let us wait and see!