Uniswap V3 Development Trends: High Capital Efficiency, Low Fees, Potential to Disrupt Centralized Exchanges?

Uniswap V3 is an update that benefits most users. If the 0.05% fee ratio can become mainstream, it is likely to truly disrupt the existing cryptocurrency trading system.

(This article is authorized to be reprinted from PANews, with the original title "Understanding the Development Trend of Uniswap V3: Can High Capital Utilization and Low Fees Disrupt Centralized Exchanges?", original article here)

Uniswap has been surprising people from V1 to the current V3. The updates in Uniswap V3 include granular control of aggregated liquidity, range orders, multi-tier fees, advanced oracles, giving users more autonomy. Among them, the ability to only allow users to customize liquidity ranges can achieve liquidity aggregation, range orders, and limit order functions.

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In Uniswap V2, all liquidity is distributed based on the constant product curve k=x*y within the interval from 0 to positive infinity. However, it is difficult for prices to reach the ends of the interval, leaving a large amount of funds idle. For certain trading pairs, price fluctuations may be limited to a very small range. Allocating funds across the entire interval would result in significant waste. Many projects have optimized this and found success, such as Curve, which chose to optimize the bonding curve, concentrating liquidity within specific ranges for trading assets like stablecoins.

In the upgrade to Uniswap V3, the concept of "Tick" is introduced, making Uniswap's trading more similar to traditional order book models.

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

When market prices fluctuate due to a transaction, they may cross several Ticks. Once the original liquidity is exhausted, liquidity will move in the opposite direction. For example, in a 0.3% fee USDT/W ETH trading pair, the price range corresponding to Ticks -205380 to -193620 is 1204.8 to 3904.9 for ETH. When the price falls below the price corresponding to Tick -205380, the liquidity from buy orders in that Tick will become sell order liquidity.

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

Higher Capital Efficiency

Comparing the data between Uniswap V3 and Uniswap V2, Uniswap V3 has captured more trading volume with lower liquidity than V2. For example, based on the data from May 28, as shown in the chart below, Uniswap V3 has a total value locked (TVL) of only $15.8 billion, but the 24-hour trading volume is $9.23 billion. In contrast, Uniswap V2 has a TVL of $57.2 billion, but the 24-hour trading volume is only $7.41 billion.

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

On SushiSwap on Ethereum, the TVL is $3.32 billion with a 24-hour trading volume of $1.42 billion.

On PancakeSwap on Binance Smart Chain (BSC), the TVL is $8.2 billion with a 24-hour trading volume of $9.2 billion.

On QuickSwap on Polygon, the TVL is $0.94 billion with a 24-hour trading volume of $2.29 billion.

From the perspective of capital efficiency, Uniswap V3 deserves to be the best decentralized exchange (DEX). Even just from the trading volume perspective, Uniswap V3, with its relatively low TVL, has become the DEX with the highest trading volume.

Trading Similar Assets

In trading similar assets, Curve, a decentralized exchange, dominates the market with low slippage and low fees (0.04%). Other DEXs usually charge 0.3% fees, which are not competitive for trades involving stablecoins with larger volumes. On the centralized exchange side, Binance offers zero fees for trading between its own BUSD and other stablecoins to expand the utility of BUSD.

With the launch of Uniswap V3, users can set liquidity for stablecoin pairs with low volatility in a very tight range, such as the USDC/USDT pair, where liquidity can be limited to a range like 0.994 to 1.005. Through high capital efficiency in a narrow range, LPs can earn rewards, offering a stablecoin trading experience similar to Curve.

Comparing trading 100,000 USDT for USDC, Uniswap would yield 100,006 USDC, while Curve would yield 100,018 USDC. Considering the gas fee difference between the two, Uniswap V3 may provide a better experience.

The yields from stablecoin pools on decentralized platforms decrease as funds flow in and the platforms mature. For example, based on data from May 28, the yield for the Y pool on Curve is the basic APY of 2.18% plus CRV rewards of 0.88% to 2.21%. Without staking CRV tokens, the composite annual yield for the Y pool is only 3.07%.

Comparing Uniswap V3 with three stablecoin pairs (USDC/USDT, DAI/USDC, DAI/USDT) with a 0.05% fee, based on the TVL and 24-hour trading volume on May 28, the calculated APYs are 8.7%, 5.7%, and 12.1%, exceeding the yields in most of Curve's stablecoin pools. Therefore, LPs providing liquidity for stablecoin pairs on Uniswap V3 can potentially earn higher yields than on Curve.

Low Fee Cross-Asset Trading

After the success of Uniswap's AMM mechanism, various DEXs emulating Uniswap have set transaction fees at 0.3%, making on-chain trading more expensive than centralized exchanges. For example, Binance charges a fee of only 0.1% for spot trading without referral rebates or other fee reductions. By using BNB for fee discounts, the fee can be reduced to 0.075%.

Uniswap V3 allows for customizable fee rates, currently offering options of 0.05%, 0.3%, and 1%. Lower fees could drive higher trading volumes, maintaining competitive APYs for LPs, potentially attracting LPs to choose the 0.05% fee rate.

Looking at the chart below, liquidity for the ETH/stablecoin pair is concentrated in the 0.3% fee tier. In pairs with a 0.05% fee, the yield for ETH/USDC and ETH/USDT is lower than for most other pairs, while the yield for ETH/DAI is significantly higher. In situations of low liquidity, daily fee earnings fluctuate significantly, and overall, the yield for ETH/stablecoin pairs with a 0.05% fee may be slightly lower than those with a 0.3% fee.

At the Consensus 2021 conference, Uniswap founder Hayden Adams revealed that Uniswap is providing funding through grants for the community to build liquidity mining smart contracts. Any project wishing to incentivize liquidity can use this contract, and if approved by community governance, UNI may launch a liquidity mining program.

If liquidity mining rewards are used for pairs with a 0.05% fee rate, it could significantly reduce transaction friction on Uniswap, potentially disrupting both decentralized and centralized exchanges, positioning Uniswap as a major competitor to Coinbase, as reported by The Wall Street Journal.

Future Trends

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

• The liquidity on Uniswap V3 will continue to grow. After the crash on May 19, the TVL of Uniswap V2 and other DEXs was significantly affected, with Uniswap V2's liquidity now only about half of its peak. However, the liquidity on Uniswap V3 has continued to grow after a brief dip.
• The growth rate of trading volume may not keep pace with the increase in liquidity. In recent days, while liquidity has been growing, the trading volume on Uniswap V3 has been decreasing due to overall market inactivity.
• The attractiveness of trading fees for regular users will continue to decrease, leading to higher risk/reward ratios. Providing liquidity in narrow ranges on Uniswap without a solid strategy poses significant risks. Although Uniswap can significantly increase capital efficiency, impermanent loss also increases proportionally. According to calculations from the htdefi-lab.xyz simulator, if liquidity is concentrated at half or double the market price, the capital efficiency is 3.41 times higher, leading to a proportional increase in impermanent loss during market volatility. Based on real-world experience, the average liquidity for the ETH/USDT pair with a 0.3% fee is much more concentrated than this. With significant market price fluctuations, aggregating liquidity may not be enough to offset fee earnings.

• Liquidity will continue to converge near market prices and adjust with market price changes. Taking the ETH/USDC pair with the best liquidity as an example, where the ETH price is 2505 USDC, liquidity is mostly distributed in the range of $2000 to $3400. The chart also shows that within the $2560 to $2600 range, there are significant liquidity providers, with one user selling all their ETH when the price surpasses this range, indicating a shift from providing liquidity to executing trades.

• Uniswap V3 will benefit from the development of Layer 2 solutions. Uniswap V3's market-making strategy will be more flexible on Layer 2, reducing the impact of gas fees. While Uniswap already has a good relationship with Optimism, the delay in the Optimism mainnet launch has prevented Uniswap V3 from deploying on Layer 2. Another Layer 2 project, Arbitrum, is about to launch, potentially gaining a first-mover advantage. Uniswap has conducted a vote on Snapshot to prepare for deploying Uniswap V3 on Arbitrum, receiving 100% support.
• New professional market-making institutions and active market-making strategies relying on Uniswap V3 will continue to emerge, possibly leading to excellent market-making pools. Projects like Lixir, Charm Alpha Vault, Visor, and Method Finance have already appeared, with brief introductions provided below.

Lixir: A market-making strategy provider for Uniswap V3 that concentrates market-making funds to ensure more liquidity near market prices as they move, helping to reduce impermanent loss.

Charm Alpha Vault: Helps liquidity achieve fund rebalancing. For instance, when the initial value of ETH and USDC is 1:1, if a market price drop causes the ETH ratio to increase, Alpha Vault first withdraws liquidity, provides liquidity again in a 1:1 ratio of available ETH and USDC, and only provides liquidity with ETH in higher price ranges.

Visor: An active liquidity management tool offering self-custody mining, reward accumulation, and time-lock features, including Visor Vault, Hypervisor, and Supervisor components. The Visor pool can lock LP NFTs to prevent projects from withdrawing funds and running away. Hypervisor can earn liquidity rewards based on predefined trading ranges. Supervisor can update Hypervisor default parameters, manage assets, and execute strategies.

Method Finance: Similar to Visor, it allows users to self-custody Uniswap LP NFTs in an NFT vault.

Conclusion

Uniswap V3 significantly improves capital efficiency, enabling it to achieve greater trading volume with only 27.6% of Uniswap V2's TVL. As professional market-making teams and active market-making protocols mature, Uniswap V3 may bring substantial profits to professional institutions, but it may become increasingly challenging for retail traders to participate due to the risks of impermanent loss.

Overall, Uniswap V3 is a beneficial upgrade for most users. Traders have improved liquidity, professional market makers can leverage their expertise and capital advantages to earn higher fees than centralized exchanges, and projects can customize fee rates and liquidity ranges to mitigate the impact of initial price fluctuations.

If Uniswap V3 can popularize the 0.05% fee rate, it could potentially revolutionize the existing cryptocurrency trading ecosystem. Based on current data, the difference in LP yields between pairs with a 0.05% fee and a 0.3% fee for the ETH/stablecoin pair is not substantial. By receiving compensation through Uniswap V3's liquidity mining, the market share for trades with a 0.05% fee may increase.