Uniswap V3 Launches, What Problem Does It Solve?

UNI+2. 95%

According to public information, the Uniswap team officially deployed Uniswap V3 to the Ethereum Mainnet on May 5, 2021. As of the time of writing, the total value locked (TVL) in the new Uniswap version has exceeded $370 million, with 24-hour trading volume reaching $228 million.

链上锁定资产以及交易额

Uniswap V3 Trading Volume and TVL, source: Uniswap

Compared to Uniswap V2's 24-hour trading volume of $1.1 billion, this performance is still noteworthy. Another point worth noting is that since the launch of Uniswap V3, trading volume on Uniswap V2 has shown a continuous downward trend, decreasing from $2.02 billion on May 4 to $1.12 billion on May 6, a drop of 44.6% over two days. Based on these data changes, we can reasonably speculate that a significant amount of funds has migrated from Uniswap V2 to Uniswap V3 during this period.

Uniswap Analytics

Uniswap V2 Trading Volume, source: Uniswap

Turning to another aspect, let's look at the market performance of Uniswap's governance token—UNI. According to OKX market data, UNI has shown a fluctuating downward trend since reaching a rebound high on May 3. As of 13:00 on May 7, UNI is reported at $39.5 USDT.

UNI/USDT

UNI /USDT price, source: OKX

Frankly speaking, the launch of Uniswap V3 is a milestone event for DeFi and even the entire cryptocurrency industry, yet UNI's relatively flat performance in the secondary market seems mismatched with the significance of this event. However, upon closer reflection, this situation is not surprising. On one hand, Uniswap V3 was originally scheduled for launch at the end of March this year, and its innovations had been fully discussed and digested by the market beforehand, reflected in UNI's price trend since January. According to OKX market data, since entering 2021, UNI has risen from a low of $4.7 to over $44, a gain of 855%. On the other hand, this aligns with the "buy the rumor, sell the news" trading strategy we often mention.

Briefly setting aside UNI's price, in the following sections we will focus on the main thread of what problems Uniswap V3 solves to understand its key innovative mechanisms.

"Improving Capital Efficiency"

Improving capital efficiency—this is the core problem that Uniswap V3 aims to solve. The Uniswap team states that the biggest change in V3 compared to previous versions is the potential to significantly improve liquidity providers' capital efficiency, with "liquidity providers' capital efficiency expected to increase up to 4000x compared to V2." This is undoubtedly the right direction. Indeed, our expectations for a crypto asset trading platform—whether CEX or DEX—include multiple aspects such as user-friendly interface design, comprehensive trading products, and efficient capital utilization, with capital utilization being paramount. In design improvements for user capital efficiency, OKX's recently launched Unified Account aligns perfectly with Uniswap V3's philosophy.

How to Improve Capital Efficiency?

In the previous article "UNI Hits New Highs, DEX Growing Rapidly But Shortcomings Remain" , we introduced the AMM (Automated Market Maker) model used by current mainstream DEXs, while mentioning a key factor restricting more liquidity providers from entering DEXs—impermanent loss. Impermanent loss occurs because under the AMM mechanism, constrained by insufficient liquidity, when the market price of crypto assets deviates in any direction, liquidity providers' assets may suffer losses. It can be said that impermanent loss and convenient trading experience are two sides of the same coin for liquidity providers in DEXs. This time, Uniswap V3 brings a new solution to the market and liquidity providers.

Centered on improving capital efficiency, Uniswap V3 introduces features such as "concentrated liquidity," "non-fungible positions," "custom fee tiers," and "range orders." The most important of these is "concentrated liquidity"—liquidity providers can allocate funds within custom price ranges, thereby creating personalized price curves. For example, liquidity providers can choose to provide liquidity only for a specific price interval to participate in market-making within that range, achieving higher capital returns. In the official Uniswap V3 introduction, an animation demonstrates the process of liquidity providers concentrating their liquidity within custom price ranges.

动画视频

V3 liquidity providers can concentrate their liquidity within custom price ranges, source: Uniswap

Simply put, concentrated liquidity adds "granularity control" to the original constant product rule "XY=K" curve. Liquidity providers can concentrate their funds within the most frequently traded price ranges to maximize returns. For example, in the past week, UNI /USDC price has mostly been within the range of 39-45 USDC. Liquidity providers can allocate their funds only to the XY=K curve within this interval, without needing to consider extreme market volatility scenarios. If the price deviates from this range, liquidity providers automatically stop loss and do not participate in trading outside the range. Through such rule settings, liquidity providers can maximally avoid impermanent loss.

Next, let's compare the different changes in returns between Uniswap V3's concentrated liquidity trading and V2 through simulation operations.

Uniswap V3 Strategy Simulator

In the V3 liquidity pool simulation, we use UNI/USDC as the trading pair. The investment amount is $1,000, meaning the initial investment consists of $500 worth of UNI and $500 worth of USDC. The current UNI to USDC exchange rate is set at $40.16.

We can set up two strategies for comparison.

Strategy 1 has a narrower price range, while Strategy 2 has a wider price range. Strategy 1's upper and lower limits are set at 39-45, indicating liquidity is provided only within this range. If UNI/USDC price exceeds 45, the trader's liquidity will entirely convert to USDC; if below 39, it will entirely convert to UNI. Strategy 2 follows the same logic.

Price Uni/USDC

Next, let's see how V3's Strategy 1 and Strategy 2 differ from V2's full price range.

The green line represents the value change of UNI/USDC liquidity in Uniswap V2. Since the liquidity pool must maintain equal value for both tokens, when the coin price changes, the quantity of coins also adjusts accordingly.

Since V2's provided liquidity has no preset upper or lower price limits, its asset value change is relatively favorable when UNI/USDC price rises. Because UNI/USDC liquidity won't entirely convert to just one token, compared to V3 Strategies 1 and 2, it can relatively maintain total asset value across the entire price range.

Now looking at V3's strategies, due to limited price ranges, liquidity largely converts to one token when approaching the range limits. We can see that both Strategy 1 and Strategy 2 almost entirely convert to USDC when UNI/USDC price approaches the upper limit, resulting in only slight increases in liquidity value during continued UNI appreciation. The logic is similar when approaching the lower limit.

From the simulation results above, when UNI price reaches $70, the initial $1,000 investment in V2 becomes $1,315; under V3 Strategy 1, it becomes $1,200.

So where are Uniswap V3's benefits? It should be noted that the above scenario assumes the strategy was set when UNI price oscillates between $39-45. In actual trading, liquidity providers would undoubtedly adjust strategies promptly based on market changes. Therefore, besides total asset value, we also need to consider liquidity providers' fee income. From the chart above, we can see that since V3 liquidity providers concentrate assets within the price range to provide trading , meaning for the same capital investment, V3 can occupy a larger proportion of liquidity within the price range, thus receiving more trading fees.

Therefore, in the simulation results, we can see that in V3 Strategy 1, fee returns are 28.46x higher than V2, while in V3 Strategy 2, fee returns are 2.77x higher than V2.

In summary, under normal circumstances, Uniswap V3 helps liquidity providers avoid impermanent loss as much as possible while also enabling them to collect maximum trading fees.

Commenting on this, Jump Capital's Peter Johnson stated: "Uniswap V3 is a major step forward for Uniswap. In how to provide liquidity in the protocol, it provides greater flexibility for market makers, making liquidity provision more attractive and making Uniswap's trading pairs more efficient for traders."

Uniswap Still Has Room for Improvement

Rome wasn't built in a day. Uniswap's perfection certainly won't happen overnight. Uniswap V3 provides constructive solutions for reducing liquidity providers' impermanent loss, but may simultaneously introduce fairness issues. OKX Research points out that in Uniswap V2, all LPs have equal status, and fees received are evenly distributed. However, Uniswap V3 improves capital efficiency through concentrated liquidity, invisibly introducing a liquidity competition mechanism to Uniswap V3—organized, professional liquidity providers will adjust their liquidity price ranges in real-time based on market price changes to obtain greater returns, while ordinary liquidity providers find it difficult to adjust promptly, resulting in relatively lower capital efficiency and fee sharing. Therefore, for these users, if an incorrect price range is selected, impermanent loss may be amplified.

Perhaps with Uniswap V3's development, when this issue gradually gains more user attention, future third-party services may emerge to help users select optimal liquidity allocation strategies. Exploring in development, moving forward while exploring—isn't this exactly the path DeFi has always taken?

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