A new standard for AMMs

The evolution of the protocol

Since its inception in 2018 by Uniswap, automated market makers (AMMs) have played a pivotal role in the emergence of decentralized finance. They have established new revenue streams for numerous users and offered them the security and convenience of trading through their own crypto wallets. To date they have amassed over $200B in trading volume and have rivaled some of the largest centralized exchanges in the industry. Uniswap V3, represents an evolution of this concept, as it introduces new features to improve the efficiency of the platform and ultimately increase the earning potential of the users who participate on it.

Greater control and precision

The centerpiece feature of V3 is how it affords liquidity providers with more precise control over how they allocate their capital. For the first time, liquidity can be allocated to specific price ranges of the market maker’s choosing. This feature which has been coined as “Concentrated Liquidity” has a two-fold benefit, one; increased market depth for tokens in pools and second, a reduction in slippage for traders. Furthermore, by concentrating the liquidity into a smaller range it will increase its capital efficiency when it is being used to sustain trades. Resulting in more fees being generated for an LP with a smaller liquidity position, than compared to V2.

To gain a better understanding of the benefits of Concentrated Liquidity, it is helpful to compare it to the structure of the previous Uniswap V2 liquidity provisioning. In V2, liquidity was distributed along an X * Y = K price curve, where buying and selling into the pool shifts the LPs position on the X * Y = K curve. The even distribution along the entire curve allows for trading across the whole price range from zero to infinity. The major drawback was that it resulted in a lot of unused liquidity if most of the trading only occurred in a narrow price range.

Liquidity Concentration

Rather than distributing liquidity along the entire curve, V3 segments the curve into straight lines with a limited length. These smaller straight lines represent the price ranges chosen by the LPs and where all the V3 liquidity will sit. A long line yields better trading price coverage, and a short line yields better fees generated per amount of liquidity provided. By segmenting the curve, it results in the full utilization of the liquidity as the price moves along the straight line, giving LP’s far greater capital efficiency and very low unused liquidity.

AMM style limit orders

While AMMs have seen an explosion in growth in recent times, the lack of Limit Orders have been a sticking point for many traders. A limit order is an order that will only execute at a predetermined price, it allows traders to buy at a lower or sell at a higher price than the current market price. This key feature has distinguished the centralized exchanges that use order books from the decentralize exchanges that are AMMs. Now, V3 has introduced a feature it coins as “Range Orders” to level the playing field between the two mediums of exchange.

Range Orders are not a one-to-one representation of Limit Orders, but they reach parity in certain areas. Traders who want to sell their tokens for another at a specific price point can provide their single asset as liquidity in a targeted price range above or below the market price. Once the market price shifts, and it enters the targeted range, the deposited tokens will be swapped for other tokens in the pool smoothly along the price curve.

Traders can now wait for the shifting market to trigger their desired tokens swaps similarly to the traditional Limit Orders, but with the added benefit of also earning fees as the trading price fluctuates within their targeted range. However, due to the unpredictable nature of the markets, the swapped asset must be removed before the price reverts back to above or below the targeted range. Else, it will be swapped back into the original deposited asset.

More sophisticated strategies

Having the ability to target specific price ranges opens the possibility for LPs to employ different strategies to maximize the earning potential of their liquidity positions. For one, LPs may choose to target a single wide price range for a moderate gain in capital efficiency to lower their risk to price fluctuations. Secondly, LPs might choose to target a single narrow price range for a large gain in capital efficiency while they increase their exposure to risk. Or finally, LPs may decide to target multiple price ranges within the same pool to increase their coverage to multiple price points while spreading out the risk.

Another area where V3 takes a step forward pertains to the fees that LPs accumulate. There are now multiple fee tiers to choose from, rather than the fixed 0.3% that was established in Uniswap V1. These flexible fees will result in more appropriate compensation to LPs in accordance to the risk of their liquidity position. To give a real word example, if a user were to provide liquidity to a low volatility asset such as a stable coin, then they might opt for the low fee tier to encourage more trading of the token. Whereas, with a high volatility asset such as a newly launched token, the user may opt for the high fee tier to offset the risk of holding the token.

The additional features of V3 will ultimately breed more competition and gamification, which is a good thing for users on the platform. Market makers will be encouraged to compete to offer the best rates in order to profit. Traders will be given the opportunity to distinguish themselves from the rest by using their skill and know-how of the

markets. All in all, it will result in greater trading volume on the platform and a shot in the arm for the whole decentralized finance sector.

With great power comes great responsibility

For proficient users, their earning potential on V3 will be much higher than that of V2. On the flip side, the margin of error for those who are not as skilled will in fact be smaller on the new protocol. For instance, with “Concentrated Liquidity” there is a real possibility of far more exposure to “Impermanent Loss”. Which is when a user provides liquidity to a pool and the market price of the asset diverges from the initial price at the time of deposit. At this point, arbitrageurs become incentivized to rebalance the pool and effectively take profit from the LPs. Concentrated liquidity increases the likelihood that the market price will move away from it and increase the composition of the LPs holdings into the weaker asset.

There is also a similar story with the “Range Orders”. As it offers no guarantee that once the market price of an asset reaches the trader’s target price range it will be swapped over for the other asset. Therefore, the responsibility is still on the trader to judge the correct time to remove their asset, to successfully perform this quasi-Limit Order. This does not diminish Range Orders as a feature, but it highlights how the users who keep up to date with the markets will be able to utilize it to its full potential.

Opening the gates for new platforms

As much progress as Uniswap V3 has made over V2, it is still not the finished article. On the one hand, it adds new tools to the arsenal of traders to help maximize profits and lower their risk. While on the other hand, it adds an extra layer of complexity to tasks that were straightforward on V2.This extra complexity reduces the margin of error and potentially can lead to unfavorable situations for some users. The good news is that often in this industry, the launch of one protocol or platform can pave the way for new projects/services to be built on top to improve the user experience. This very well may be the case with V3, as it could spawn services that can help clients to optimize their strategies while managing the complexity on their behalf.

Next Steps:

Here are some quick links to get updated with the happenings in Pilot Protocol.

References

https://ethresear.ch/

https://uniswap.org/whitepaper-v3.pdf

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