Uniswap Spearheaded the First AMM Era; its V3 May Usher in a New One

Uniswap launched its third and most comprehensive update yet. This new version of DeFi’s largest decentralized exchange by traded volume has the potential to usher in a new era for automated token swaps.

The most notable change is that with Uniswap V3 decentralized trading becomes more capital efficient as liquidity providers can now set price ranges between which to provide liquidity. While previously, LPs’ positions were represented with a standard, fungible Ethereum token, an ERC20, they will now be represented by a non-fungible token, an NFT, to reflect that LPs are now providing capital within a specific range. Uniswap founder Hayden Adams yesterday tweeted he is the “proud owner” of the DEX’s first NFT.

Uniswap popularized automated market making in DeFi. AMMs rely on pools of tokens and prices set by a standardized formula, allowing for swaps to happen between any two tokens, even if there are no counterparties, as the swap happens directly with smart contracts. The mechanism also encourages anyone to provide liquidity to the DEX in exchange for trading fees. While this model has ruled DeFi, Uniswap might be about to change that with this upgrade. This time though, it has protected its code to prevent dozens of copies from springing up, like they did in its past iteration. Integrating with the project’s contracts, for example through DEX aggregators, will remain accessible.

Capital Efficiency

The number one pair in terms of volume after the launch yesterday is USDT/USDC with $2.3M of value traded. Highlighting the concentrated liquidity functionally, essentially all the liquidity provided falls between the $0.97 and $1.03 range with the vast majority of that liquidity falling within fractions of a cent from the $1 price that both tokens generally maintain. Previously, liquidity would have been distributed along a curve, meaning capital at the extremes would be largely unused.

V3’s concentrated liquidity means that DeFi’s most popular metric, total value locked, won’t have as much significance relative to trading volume. The ratio between volume and TVL should highlight AMMs’ increased capital efficiency.

Digging in, the ratio between the $2.30M in volume that the $19.55M locked in the V3 USDT/USDC trading pair has facilitated is 0.12. That’s higher than the ratio of 0.07 for the same pair on V2, which has $6.68M in 24-hour volume on $101.59M of TVL. The former is almost twice as high as the latter, showing that the capital in V3 is almost twice as efficient as in V2 for the USDT/USDC trading pair.

As liquidity providers adapt to Uniswap’s V3, and as developers create products which automatically reconcentrate liquidity positions around current prices, the degree of capital efficiency in all of DeFi will likely improve, Adams suggested in a V3 AMA on Discord.

Trading Strategies

Uniswap’s new model is already delivering on new ways to track the DeFi market. Liquidity spreads for more volatile pairs like ETH/WBTC signal how liquidity providers think the ratio between the two assets will change. The liquidity distribution chart shows more liquidity above the ratio of 0.06 than below, meaning that LPs are presumably betting that ETH will move higher relative to BTC in the short-term.

It’s easy to imagine investors are already cooking up trading strategies to leverage this information.

While concentrated liquidity improves capital efficiency, and should in theory, narrow buy and sell spreads, the downside is that traders could end up with no liquidity on price ranges for some tokens.

There could be “liquidity black spots,” said 0xNick, as he goes by on Twitter, Product Owner at NFTX. In the long-run though, he believes that “the free market will handle proper liquidity provision.”

Bring on the NFTs

NFTs of liquidity positions have color schemes unique to each liquidity pool, in addition to a depiction of the liquidity curve and price ratio between tokens at the time of deposit.

According to Adams, the contract which generates the SVG files for the NFTs is the only upgradable contract in V3. The Uniswap founder says that Uniswap governance will be able to vote on the next SVG generator contract, creating a new suite of images based on the LP position’s parameters.

In a poll, andy, as he goes by on Twitter, who works on the Fractional protocol which fractionalizes NFTs, asked whether “the first v3 LP NFT for important DeFi pairs will carry a value greater than the tokens it represents.”

If yes, this would mean a rational actor would rather sell their NFT representing their LP positions, rather than unlocking the liquidity. If the NFT accrued no additional value it would just be worth the underlying assets’ value.

The results of the poll were middling with 41.3% of the 501 votes agreeing, 27.5%, and the rest asking for answers.

Overall, the use of NFTs to represent liquidity positions, represents the continued blurring of the line between NFTs and DeFi, as 0xNick told The Defiant.

Products on Products

In the V3 AMA, Uniswap growth lead Ashleigh Schap said the team immediately started working on V3 upon the completion of V2. Now that V2 is shipped she says the Uniswap team plans “to be much more open with our development processes and really wants to see more community development happening on some of the stuff that we think needs to be built.”

Regarding some of the tools the team would like to see developed, Adams listed the opportunity to build better decentralized oracles, tools for managing the newly introduced complexities to LP positions, and a system for making the range orders feel more like limit orders.

Range orders point to a V3 feature which allows users to provide only one-side of a trading pair’s liquidity, as long as it’s outside of the current price. If the price enters moves to that range, the provided token will swap for the unprovided token smoothly along the allotted range.

Uniswap’s V3 launch looks more like a beginning than an end, with new products to be built on top as well as new trading strategies to be deployed based on the additional functionality. With the largest treasury in DeFi according to Open-Orgs at $7.1B, Uniswap governance has more than enough capital to incentivize some of the building itself.