Leading Ethereum-based decentralized exchange Uniswap in March announced the launch of the protocol’s third version. Shortly before the announcement, its founder Hayden Adams wrote the following:
\n\n
“If I have to go another week without publicly announcing the details of Uniswap v3, I could go mad.”
\n\n
A few days later, the team behind the decentralised exchange hinted at the forthcoming launch of the new protocol version, releasing a stylish video.
\n\n
\n
🦄🦄🦄 pic.twitter.com/uEdz2qiqgL
\n
— Uniswap Labs 🦄 (@Uniswap) March 22, 2021
\n
\n
\n\n
What interesting features will the developers present in the May 5 release? How radical are these updates and will they help Uniswap maintain leadership in a highly competitive segment? ForkLog has analysed the innovations of the third version of the most popular Ethereum exchange.
\n\n
- Uniswap is becoming increasingly hard to compete with other DEXes such as Curve, SushiSwap and the BSC-based PancakeSwap. The forthcoming update is designed to fix this.
\n\n\n
- The third version of the exchange envisages radically new functions and concepts, including concentrated liquidity, range-limit orders and multiple positions within a single pool.
\n\n\n
- Shortly after the release of the new version, developers will implement the second-layer scaling solution Optimism.
\n\n
A standard-bearer among automated market makers
\n\n
Uniswap is a non-custodial and open (permissionless) protocol for exchanging tokens on the Ethereum network.
\n\n
The launch of the first version of this decentralised exchange (DEX) took place in November 2018. The trading platform gained popularity at a modest pace until May 2020, when the second version began operating. Its main innovation was the introduction of liquidity pools, allowing direct exchange of ERC-20 tokens (whereas the previous version only had ERC20-ETH pools).
\n\n
Against the DeFi buzz, Uniswap v2 demonstrated exponential growth in its user base and total value locked (TVL). Activity on the exchange began to exert significant load on the Ethereum blockchain, driving up gas costs for all network users.
\n\n
\n\n
Soon, Uniswap became the most popular DEX on Ethereum. Essentially, it became the standard among platforms based on the automated market maker (AMM) mechanism.
\n\n
\n\n
A number of Uniswap forks emerged. The most well-known are the \”vampire\” project SushiSwap and PancakeSwap on the Binance Smart Chain (BSC).
\n\n
Within less than a month after the v2 launch, the exchange’s turnover accumulated surpassing $180 billion.
\n\n
\n\n
The weekly trading volume surpassed the $10 billion mark — a figure comparable to top centralized exchanges.
\n\n
However competitors are not sleeping: the leading BSC project PancakeSwap is catching up with Uniswap in daily turnover and has already surpassed it in the number of transactions, users, and TVL.
\n\n
\n\n
It appears that PancakeSwap and other BSC platforms attract retail users who value speed and low fees, not decentralisation. Maintaining leadership in the segment becomes harder, which means Uniswap needs breakthrough innovations.
\n\n
Just before the release of the significantly improved second version, developers had already begun work on Uniswap v3, revealing details only in March 2021. Let us review the main changes.
\n\n
v3
\n\n
The release of the third version of Uniswap is scheduled for May 5. The developers have promised to implement the second-layer scaling solution Optimism soon after the release.
\n\n
It is differentiated from the previous version by a focus on capital efficiency, achieved through concentrated liquidity, a core concept of Uniswap v3.
\n\n
When in the second version participants deposit funds into a pool, liquidity is evenly distributed along the price curve — from 0 to ∞. This approach implies inefficient use of capital, since assets typically trade within defined ranges.
\n\n
This is especially noticeable in pools with stablecoins. For example, the DAI/USDC pool on Uniswap uses only 0.5% of liquidity providers’ capital for the range $0.99-$1.01 — that is where the overwhelming majority of trades occur. This means the remaining 99.5% of funds are effectively not used.
\n\n
In the third version, LPs will be able to choose a specific price range to provide liquidity. This will allow market participants to concentrate capital where the main trading activity takes place.
\n\n
\n\n
In other words, for liquidity providers Uniswap v3 offers individual price curves. LP earnings from trading fees are directly proportional to the liquidity they provide for a given range.
\n\n
To illustrate the mechanism, suppose Alice and Bob decide to provide liquidity in the USDC-ETH pool. Each has $10,000, and the current Ethereum price is $2,700.
\n\n
Alice contributed 5,000 USDC and 1.85 ETH to the v2 liquidity pools, thereby splitting her capital evenly between the two assets.
\n\n
Bob wanted to test the new concentrated liquidity feature in Uniswap v3. He chose not to deploy all his funds into a single pool. Selecting a price range between $2,200 and $3,200, Bob deposited only 600 USDC and 0.22 ETH. The remaining $8,800 he deployed elsewhere.
\n\n
Despite the substantial difference in capital, Alice and Bob would earn the same trading fee income while the ETH price stays in the $2,200-$3,200 range. By choosing the new Uniswap version and an optimal price range, Bob made his capital work many times more efficiently.
\n\n
Moreover, he significantly reduced risk. If the ETH price were to fall to $0, Bob would lose 12% of his capital, while Alice would lose all of hers.
\n\n
In pools with stablecoins, liquidity providers are likely to choose even narrower ranges. In the Uniswap blog the post says that the return from $25 million placed in the $0.99-$1.01 range of the DAI-USDC pool of Uniswap v3 would correspond to $5 billion of liquidity in a comparable v2 pool while the price remains in that same range.
\n\n
Developers claim that the maximum capital efficiency of Uniswap v3 is up to 4,000 times higher than v2. Over time, the figure could reach 20,000 as layer-2 gas-reducing solutions mature, allowing the price-range step to be reduced from 0.1% to 0.02%.
v3 also introduces the concept of active liquidity. If the price leaves the designated LP range, liquidity is effectively removed from the pool, stopping to earn fees.
\n\n
\n\n
When this happens, liquidity flows entirely into one of the pool’s assets. At that point LP can either wait for the price to return to the specified range or adjust the price range to a more current one.
\n\n
In the future, more rational capital deployment by liquidity providers is expected. The latter are likely to focus mainly on narrow ranges.
\n\n
It is possible that some LPs will focus on less probable but more profitable price corridors. Some will operate tactically, updating settings when prices move out of range.
\n\n
The concept of concentrated liquidity also enables range-limit orders. They allow LPs to earmark tokens of one type for a given range above or below the current price. When the price enters the user-specified corridor, one asset is sold for another. Using this feature within a narrow range can achieve an effect similar to a standard limit order.
\n\n
Suppose the DAI/USDC quote is below $1.001. An LP could deposit 1 million DAI, choosing the corridor $1.001 to $1.002. As soon as DAI trades above $1.002, all liquidity provided by the LP is converted to USDC.
\n\n
At that moment, the LP can withdraw funds to avoid automatic conversion back to DAI if quotes in the pair fall below $1.002.
\n\n
\n\n
Multiple positions. LPs can provide liquidity in the same pool according to different price ranges, which may partially overlap.
\n\n
“For example, an LP could deposit $100 into the ETH/DAI pool for the price range $1,000-$2,000, with an additional $50 for the range $1,500-$1,750,” explained Uniswap representatives.
\n\n
According to them, the new option opens up new, more advanced trading strategies.
\n\n
Non-Fungible Liquidity [Non-Fungible Liquidity]. To implement the above features, developers had to make some compromises.
\n\n
“A side effect of customised price curves is that liquidity positions are no longer interchangeable and are not represented as ERC-20 tokens in the main protocol,” noted the developers.
\n\n
Instead, liquidity positions will be represented as non-fungible tokens (NFT).
\n\n
“However, positions can be made interchangeable through the use of external contracts and partner protocols. In addition, trading fees are no longer automatically reinvested back into the pool on behalf of the LP,” — explained in the Uniswap blog.
\n\n
In whitepaper the following is stated:
\n\n
“Fees accrue are stored separately, in the form of tokens in which these fees are paid.”
\n\n
Developers anticipate more sophisticated strategies for liquidity providers, aiming to earn passive income.
\n\n
“These could include multi-positions, auto-balancing for concentration around the market price, reinvesting fees, lending, and much more.”
\n\n
Flexible fees. Uniswap v3 features a three-tier fee structure for liquidity providers (0.05%, 0.3% and 1%).
\n\n
This structure will give LPs the option to choose pools in line with their risk tolerance. For example, the ETH/DAI pair is more volatile than USDC/DAI, and thus entails higher risk.
\n\n
Uniswap expects that 0.05% fees will be typical mainly for stablecoin pairs. The 0.3% level will apply to pools like ETH/DAI, and 1% to much more volatile pairs with low-liquidity assets.
\n\n
As with v2, the community will have the option to vote on enabling the feature to redirect a portion of LP fees to UNI holders. After launch, the option will initially be inactive.
\n\n
Additionally, Uniswap v3 will optimise TWAP oracles. TWAP oracles were introduced in the previous version. But in v3 their efficiency will be substantially higher, and computation costs in external smart contracts will be reduced.
\n\n
It is also worth noting that Uniswap is changing its license. Business Source License 1.1 will give the project greater leeway to protect its innovations from copying. The new license will not impede integration with wallets and other mobile apps.
\n\n
The current license will lapse after two years. In the future, UNI token holders will be able to adjust Uniswap’s licensing terms.
\n\n
Conclusions
\n\n
The features announced by the developers look highly innovative and original. The emphasis on flexibility and capital efficiency seems timely.
\n\n
On the other hand, providing liquidity to pools has become a more complex process. In the second version, newcomers and seasoned participants were on an even playing field, with similar risk/reward profiles within the same pool.
\n\n
Now, retail LPs are likely to compete with professional market makers, many of whom will continually rebalance liquidity around the market price and optimise strategies to maximise trading-fee income.
\n\n
Expect a new generation of yield-aggregator services. These will attract retail investors’ funds and place capital according to various strategies, reinvest revenue, and optimise gas costs.
\n\n
Developers promise that the cost of token swaps on Uniswap v3 will be \”slightly cheaper\” even before the Optimism rollout. Gas-usage optimisation is particularly timely given the platform’s load on the Ethereum network.
\n\n
These innovations are likely to push other AMM platforms to offer countermeasures. Competition in the sector will intensify.
\n\n
Layer-two solutions will keep proliferating. This will make Ethereum-based platforms once again attractive to retail users, who are sensitive to a $100 gas charge for a simple token swap.
\n\n
The price of Ethereum has already reacted positively to the forthcoming release, approaching the psychological $3,000 mark. The asset’s 30-day rise has exceeded 50%, according to CoinGecko.
\n\n
Whether the price-embodied market expectations will prove accurate remains to be seen in the near term. In any case, the influx of new participants into the crypto industry is unlikely to dry up in the medium to long term.
\n\n
Subscribe to ForkLog’s Telegram news: ForkLog Feed — all the news, ForkLog — the most important news, infographics and opinions.
“