A brief description of the changes in Uniswap V3 and its new features

Uniswap V3 can be a game changer for AMM.

A brief description of the changes in Uniswap V3 and its new features

What is the long-awaited Uniswap V3? How is it different from V2? Will it be a game changer when it comes to the automated market maker space? Will it launch directly on Layer 2? You will find the answers to these questions in this article.

Uniswap

While Uniswap, one of DeFi’s core projects, doesn’t need much introduction, let’s take a quick look at a few key points before we get into our V3 research.

Essentially, Uniswap is a protocol for decentralized and permissionless exchange of tokens on the ethereum blockchain.

The initial version of Uniswap was released in November 2018 and gradually began to attract user interest.

In May 2020, at the beginning of DeFiSummer, Uniswap launched a second version of the Uniswap V2 protocol.

A brief description of the changes in Uniswap V3 and its new features

The main feature is the addition of an ERC20/ERC20 liquidity pool to the ERC20-ETH pool that existed in V1.

In the second half of 2020, Uniswap V2 experienced a period of parabolic growth and quickly became the most popular application on Ether. It also became almost the standard for automated market makers (AMM), making it one of the most forked projects in the entire DeFi space.

In less than a year since its launch, V2 has facilitated over $135 billion in trading volume, a staggering number that rivals the top cryptocurrency exchanges.

You can learn more about the full story behind Uniswap V1 and V2 in this article.

It is also worth understanding the concept of liquidity pools and automated market makers.

V3

Just before the release of V2, the team behind Uniswap had already started working on a new version of the protocol, the details of which were just announced at the end of March 2021. The team has decided to launch Uniswap V3 (Ethernet Layer 2 extension solution) on the Ethernet mainnet and optimistic, with a release scheduled for early May.

This is clearly one of the most anticipated announcements in DeFi’s history, and it looks like V3 could revolutionize the AMM space.

So what are the main changes?

Compared to V2, Uniswap V3 is dedicated to maximizing capital efficiency. This not only enables liquidity providers to achieve higher returns on capital, but also significantly improves trade execution capabilities that now rival and even surpass the quality of centralized exchanges and stablecoin-centric AMMs.

Most importantly, with greater capital efficiency, liquidity providers can create overall portfolios that significantly increase exposure to preferred assets and reduce their downside risk. They can also add a single asset as liquidity to a range of prices above or below the current market price, which essentially creates a fee-limit order that executes along a smooth curve.

This is all possible by introducing a new concept of concentrated liquidity.

In addition to this, V3 introduces several fee tiers and improves the Uniswap oracle.

Now, let’s introduce some features of Uniswap V3 one by one in order to better understand them.

Centralized liquidity

Centralized liquidity is the main concept behind V3.

When a liquidity provider provides liquidity to a V2 pool, liquidity is distributed equally along the price curve. While this allows for dealing with all price ranges between 0 and ∞, it makes for very inefficient capital. This is because most assets typically trade within a certain price range. This is especially true in pools that have stable assets and trade in a very narrow range. For example, the Uniswap DAI/USDC pool uses only about 0.5% of its capital to trade between $0.99 and $1.01, a price range that underlies the vast majority of trading volume. This is also the main source of transaction fees for liquidity providers.

This means that in this particular example, 99.5% of the remaining capital is almost never used.

In V3, the liquidity provider has the option to customize the price range when providing liquidity. This allows to concentrate capital in the range where most of the trading activity takes place.

A brief description of the changes in Uniswap V3 and its new features

To achieve this, V3 creates individualized price curves for each liquidity provider.

Prior to V3, the only way to allow liquidity providers to have separate curves was to create a separate pool for each curve. If trades had to be traded across multiple pools, these pools (if not aggregated together) would result in high gas fee costs.

It is important that users trade with the portfolio liquidity available at a particular price point. This portfolio liquidity is derived from all price curves that overlap at that particular price point.

Liquidity providers earn transaction fees that are proportional to their liquidity contribution over a range.

Capital Efficiency

Concentrated liquidity provides better capital efficiency for liquidity providers.

To understand it better, let’s look at a simple example.

A brief description of the changes in Uniswap V3 and its new features

Alice and Bob both decided to provide liquidity in the ETH/DAI pool of Uniswap V3. They each have $10,000 and ETH is currently priced at $1750.

Alice allocates her entire capital to ETH and DAI and deploys it over the entire price range (similar to V2). She deposits 5,000 DAI and 2.85 ETH.

Instead of using all of his funds, Bob decided to pool his liquidity and fund it in a price range of 1500 to 2500. He deposited 600 DAI and 0.37 ETH for a total of $1,200 and used the remaining $8,800 for other purposes.

Interestingly, they earn the same transaction fee as long as the ETH/DAI price stays between 1500 and 2500. This means that Bob can only provide 12% of Alice’s capital and still earn the same return. Making his capital 8.34 times more efficient than Alice’s capital.

Most importantly, Bob puts his entire capital at a lower risk. If ETH is unlikely to fall to $0, then Bob and Alice’s entire liquidity will be transferred to ETH. While they both lose all of their capital, Bob takes on much less risk.

In a stable pool, liquidity providers are likely to provide liquidity within a particularly narrow range. If the $25 million currently held in the Uniswap v2 DAI/USDC pool is concentrated within the 0.99 – 1.01 price range in v3, it will provide the same depth as the $5 billion in Uniswap v2 as long as the price stays within that range.

A brief description of the changes in Uniswap V3 and its new features

When V3 is activated, the maximum capital efficiency will be 4,000 times greater compared to V2. This will be achievable when providing liquidity in a single 0.1% price range. Most importantly, V3 pool plants will be able to support ranges of up to 0.02%, which implies a maximum capital efficiency of 20,000x relative to V2.

Active Liquidity

V3 also introduces the concept of active liquidity. If the price of an asset traded in a given liquidity pool exceeds the liquidity provider’s price range, then the liquidity provider’s liquidity is effectively removed from the asset pool and it stops earning fees. When this happens, the liquidity provider’s liquidity will be fully transferred to one of the assets and they will eventually hold only one of the assets. At this point, the liquidity provider can wait until the market price returns to within their specified price range, or they can decide to update their range to take into account the current price.

A brief description of the changes in Uniswap V3 and its new features

While it is entirely possible that there will be no liquidity in a given price range, this would actually create a huge opportunity for liquidity providers to provide liquidity into that price range and start charging all transaction fees. From a game theory perspective, we should be able to see a rational allocation of capital, with some liquidity providers focusing on a narrow price range, others focusing on capital that is less likely but has a higher profitability range, and others choosing to update the price range as prices move beyond the previous range.

Range Restricted Orders

Range-limited orders are the next feature of Aggregate Liquidity.

A brief description of the changes in Uniswap V3 and its new features

This allows liquidity providers to offer individual tokens as liquidity within a custom price range above or below the current market price. When the market price enters the specified range, one asset will be sold to another on a smooth curve. All the while still earning transaction fees in the process.

When used with a narrow range, this feature achieves similar goals to a standard limit order that can be set at a specific price.

For example, suppose the DAI/USDC is trading below 1.001. The liquidity provider may decide to deposit its DAI in a narrow range between 1.001 and 1.002. Once the DAI trades above 1.002 DAI/USDC, the entire liquidity provider’s liquidity will convert to USDC. at this point, the liquidity provider must withdraw its liquidity to avoid automatic conversion back to DAI once the DAI/USDC returns to trading below 1.002.

Multiple Positions

The liquidity provider may also decide to offer liquidity in multiple price ranges that may or may not overlap.

A brief description of the changes in Uniswap V3 and its new features

For example, liquidity providers can provide liquidity for the following price ranges for ETH/DAI pools: – Between $2000 and $1500 – $2500 – Between $100 and $2000 – $3000 – Between $500 and $3500 – $5000

The ability to enter multiple liquidity provider positions in different price ranges can approximate almost any price curve or even orders. This also allows for the creation of more complex market maker strategies.

Irreplaceable liquidity

Since each LP can essentially create its own price curve, liquidity positions are no longer fungible and cannot be represented by the well known ERC20 liquidity provider token.

A brief description of the changes in Uniswap V3 and its new features

Instead, the liquidity provided is tracked by the irreplaceable ERC721 token. Nevertheless, LP positions that appear to be in the same price range will be able to be represented by ERC20 tokens through peripheral contracts or other partner agreements.

Most importantly, transaction fees are no longer automatically reinvested into the liquidity pool on behalf of the liquidity provider. Instead, peripheral contracts can be created to provide such functionality.

Flexible fees

The next new feature is the flexibility of transaction fees. instead of offering the standard 0.3% transaction fee known from Uniswap V2, V3 initially offers 3 separate fee tiers – 0.05%, 0.3% and 1%. This allows liquidity providers to choose asset pools based on the risk they are willing to take. the Uniswap team expects the 0.05% fee to be used primarily for similar pools (e.g. different stablecoins), with 0.3% charged for other standard pairs (e.g. ETH / DAI) and 1% for other unique currency pairs.

A brief description of the changes in Uniswap V3 and its new features

Similar to V2, V3 can also enable protocol fee switching, which redirects a portion of transaction fees from the liquidity provider to the UNI token holder. instead of having a fixed percentage as in V2, V3 offers LP fees of 10% to 25% on a per-pool basis. Although it can be turned on at any time under Uniswap governance, it will be turned off at startup.

Advanced Prophecy Machine

Last but not least is the major improvement of Uniswap V2 for TWAP oracle. With V3, it is possible to calculate any latest TWAP within the last 9 days in a single chain call.

Most importantly, the cost of keeping the oracle up to date is reduced by about 50% compared to V2.

These are almost all of the major features behind Uniswap V3.

A brief description of the changes in Uniswap V3 and its new features

Interestingly, all these features do not lead to an increase in the cost of gas fees. On the contrary, the most common feature is that a simple exchange will be about 30% cheaper than its V2.

Summing up

Uniswap V3 can be a game changer for AMM. It basically combines the benefits of standard AMM with the benefits of stable asset AMM. All this makes the capital more efficient. This makes V3 a very flexible protocol that can accommodate a wide range of different assets.

It will be interesting to see how V3 will affect other AMMs, especially those that V2 couldn’t compete with before (e.g. stablecoin AMMs like Curve).

Launching V3 in parallel on Optimism is also crucial.

Optimistic is a Layer 2 scaling solution based on optimistic rollup that enables fast and cheap transactions without sacrificing Layer 1 security. Optimism is now partially available and has started to integrate with a few selected partners such as Synthetix.

Layer 2’s Uniswap should attract more users who are priced out by Layer 1’s high gas fees.

Allowing deployments to Optimism’s exchanges will be another big step in the rapid adoption of V3 on Layer 2.

In addition to the V3 release, the upcoming full launch of Optimism will obviously be another event to look forward to.

On top of that, the migration from V2 to V3 will take place on a completely voluntary basis. In the case of the V1 to V2 migration, V2 took 2 weeks over V1’s mobility. If Uniswap’s governance decides to further encourage liquidity providers by voting on some kind of incentive that exists only in V3, perhaps another liquidity mining scheme?

A brief description of the changes in Uniswap V3 and its new features

With the ultra-high capital efficiency of V3, even distributing the available liquidity on Optimism between V2, V3 and V3 on Optimism is still sufficient to enable low slippage trading between the 3 protocols.

One challenge with V3 is that providing liquidity can become somewhat difficult, especially for less skilled users. Choosing the wrong price range may increase the likelihood of impermanent loss impact, and it is interesting to note that the development of third party services helps in choosing the best liquidity allocation strategy.

So what do you think of Uniswap V3 and will this be a game changer in the AMM space and will Uniswap bring more users to DeFi on Optimism?

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/a-brief-description-of-the-changes-in-uniswap-v3-and-its-new-features/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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