Over the past year, Uniswap has cemented its status as the most prominent decentralized exchange (DEX) with around 190,000 active weekly traders and nearly $8 billion in weekly volume. Even with other DEXes in the ecosystem incentivizing LPs through lucrative liquidity mining rewards programs, Uniswap commands 60% of the DEX market share.
After 18 months of research, Uniswap unveiled v3 with new features, including concentrated liquidity and non-fungible LP positions. Uniswap v3 plans to launch to mainnet on May 5, with support for Optimism following shortly after.
Concentrated Liquidity
Uniswap v3 introduces concentrated liquidity, allowing LPs to allocate their capital to specific price ranges. For example, a WBTC/USDC LP can designate their liquidity only to be used when the pair is trading between $58,000 and $59,000. In v2, assets are pooled together and allocated across all prices from 0 to infinity. The majority of trades for a pair occur within a relatively small price range, so shifting to concentrated liquidity is much more capital efficient, with liquidity having a much higher utilization rate.
For concentrated liquidity to work, Uniswap is implementing ticks, which can hold liquidity within a specific price range. Each tick has its own set of LPs. Smaller trades should theoretically not need to span multiple ticks, but larger and higher slippage trades can span multiple once liquidity from the initial tick is exhausted.
While there are benefits to concentrated liquidity, there are some potential unanswered questions. First off, LPs won’t be able to use a passive strategy like in v2; however, protocols like Sommelier Finance and Popsicle Finance will have the opportunity to actively deploy LP capital. Second, with most trades occurring in a small price range, it is likely that LPs will naturally concentrate their liquidity around there. While this is great for low slippage trades, what happens in periods of high volatility such as a flash crash? Will traders be locked in on Uniswap and resort to using other DEXes?
Lastly, larger slippage trades that span multiple ticks will be more expensive for both traders and liquidity providers. High gas fees are already pricing out smaller players, so having Optimism launch on time will dramatically increase the effectiveness of v3
Non-Fungible Liquidity
Uniswap v2 LPs received an ERC20 token for depositing liquidity in a pool. From there, LPs could deposit the LP token into other DeFi protocols to gain yield.
Uniswap v3 upends this model with concentrated liquidity, making LP positions non-fungible. For example, a $0.99 to $1.01 price tick DAI/USDC LP token can not be freely traded with an LP token in a different price range. Using NFTs solves the tokenization of liquidity positions but breaks Uniswap’s LP token composability within the ecosystem.
Warp Finance, a lending protocol for LP tokens, already declared it has built compatibility for v3 LP tokens. Other protocols, including Indexed Finance and Visor Finance, have mentioned they’re building on top of Uniswap v3 as well.
Flexible Fees
Uniswap’s current fee model distributes 0.30% of each transaction to LPs based on their pool share. There is also a non-active protocol fee, which would allocate 0.05% of each transaction to UNI holders, reducing LP fees to 0.25%. Uniswap’s governance can create a vote to change the fee.
Uniswap v3 introduces a new multi-tier fee model with LPs having the ability to earn 0.05%, 0.30%, or 1% of transactions. Additionally, governance can allocate 10% to 25% of LP fees to token holders on a per pool basis. In theory, less volatile pools (similarity pegged assets) would have smaller fees while more volatile pairs would have more.
While v3’s new fee structure gives way to more customizability, there are some lingering concerns when it comes to relying on governance to decide fees. With over 35,000 token pairs in Uniswap v2, changing fees on a per pool basis does not seem feasible. While most volume is driven by a fraction of the overall pools, having an approach like Kyber’s dynamic fees might make the process run more smoothly.
Uniswap’s governance has also been hesitant to turn on the fee switch in v2. While we’re looking at a relatively short period since v2 has been around for less than a year, history tends to repeat itself. With only five prior governance proposals, changes to Uniswap occur less frequently than some of its counterparts.
BSL 1.1 License
Since the creation of Sushiswap in August of 2020, there has been tension amongst Uniswap and other protocols using its code. To prevent a similar situation from happening again, Uniswap will deploy v3 under the Business Source License (BSL) 1.1.
While there are other open source licenses like MIT, BSD, or GSD, the BSL 1.1 offers a solution to keep code open source while preventing unauthorized use. The BSL 1.1 does not affect integrations with v3, but does prevent other protocols from using the code in a commercial or production setting for two years. After two years, the code will convert to a GPL license. Uniswap will allow governance to make changes to the license at any point.
Enforcing the license may appear difficult given the decentralized nature of these protocols; however, there are a few workarounds. The potential threat of retribution against third parties would likely scare away investors and other protocols from interacting with any protocol illegally using the code. A second concern would be anonymous founders and teams; however, remaining anonymous would prove difficult for anyone behind a project that grows large enough to be a legitimate competitor to Uniswap. While Satoshi Nakamoto is the obvious outlier, he never cashed out.
Since most other protocols use permissive open-source licenses, it will be interesting to watch how this situation plays out and how other protocols react.
Conclusion
Uniswap v3 introduces a more sophisticated DEX model with concentrated liquidity and non-fungible liquidity positions. While v3 can improve upon capital efficiency, LPs will no longer be able to deploy passive strategies to stay competitive. With concentrated liquidity, Uniswap will cater towards more active strategies and can draw in more sophisticated players to the space.
