Thanks to the original author Momir Amidzic (IOSG) and co-author Danning Sui (0x Labs) for their support of the article!
Uniswap v1 and v2 implement a simple unified XYK pricing curve. When large transactions occur, liquidity is guaranteed at low asset utilization and exponentially increasing prices in any price range. Therefore, the only way to reduce price slippage is to increase the K value, which is achieved by attracting more capital to the pool, i.e. by increasing the total locked position (TVL).
Advantages of Range Orders
V3 is much less dependent on TVL because it allows liquidity providers to establish multiple positions within a specified price range. Thus, the concept of pooling liquidity around market prices replaces the concept of “unlimited” liquidity.
Source: Uniswap v3 Whitepaper
The method of pooling liquidity is not new in DeFi, Curve and DODO have been practicing it from different perspectives for some time. However, Curve focuses solely on stablecoins, while DODO uses a price prediction machine to pool liquidity around market prices.
Both Curve and DODO are designed around passive liquidity provision, nevertheless, V3 achieves capital efficiency by relying on the concept of rational liquidity providers who “can keep their liquidity active by concentrating it in a narrow region around the current price and adding or removing tokens as prices move, thereby reducing their cost of capital.”
Conceptually, this makes sense; but what about in practice?
To view v3’s performance, it is natural to first check whether it does indeed reflect an increase in capital efficiency. One way to measure efficiency gains is to look at the speed of capital turnover of v3 relative to v2. Thus, we look at the daily TVL turnover rate and compare it to v2 and Sushiswap.
As shown in the chart above, the TVL turnaround for v3 is much faster than v2 or Sushiswap. For example, during the peak May 19 market crash, the $1 TVL provided to v3 translated into over $1.7 in daily trading volume. v3 is a big improvement over v2. In the same situation, V2 only generated about $0.2 in daily trading volume.
Capital efficiency is indeed one of the features of v3!
Another aspect is whether v3 offers better prices than v2. Usually when using v3, we get the following information.
One way to compare is to examine the volume of trades assigned to v2 vs. v3 by the DEX aggregators. For this purpose, we examined the two largest DEX aggregators, Matcha and 1inch. both aggregators offer the best prices to end users, so they send most of their volumes to the most competitive venues.
In general, as shown in the figure below, we observe a trend that aggregators allocate most of their volumes to the latest Uniswap version, implying better pricing.
Aggregators have two ways to introduce on-chain liquidity – through a bridge contract, or through “VIP” routing directly to the Uniswap pool. The latter is optimized to save more gas fees than Uniswap’s own routing. Therefore, taking the gas fee into account will adjust to a better price. Currently, neither Matcha nor 1inch has VIP routing enabled. This suggests that Uniswap V3’s mobility can be more competitive than the current data suggests.
The other side of the coin
After discussing the advantages of the recent upgrade, we also need to examine the potential drawbacks of the new design.
Here is a reminder to the reader that one of the problems with v2 is the impermanent loss faced by liquidity providers. Assuming that price discovery occurs primarily on centralized exchanges, there is an arbitrage opportunity for any price difference: buying undervalued tokens from the pool or selling overvalued tokens to the pool.
V3 does not address the problem of impermanent losses, but the size of the losses can be determined by the behavior of LPs. That is, in V2, LPs are relatively static with respect to arbitrage, while in V3, both LPs and arbitrageurs have pricing power. This creates an interesting dynamic between the two, with roughly two possible scenarios.
In the first case, the LP can restrict the arbitrageur. This requires the sophisticated LP to constantly adjust its price range to correctly map market price changes before the arbitrageur makes a move, thus protecting the LP from arbitrage in a highly volatile market.
The second scenario is for less mature LPs and is beneficial to arbitrageurs. That is, a narrow price range means greater depth of liquidity and a higher risk of suffering losses in a volatile market environment.
Suppose we offer ETH liquidity as shown in the chart below. Our capital does not become active until the price of ETH exceeds $2,817.50. Assuming the price of ETH eventually rises above $3138.8, the LP’s position will consist entirely of DAI and the LP’s exposure to further rises in ETH will be zero. After that, the DAI will be illiquid until the ETH price falls back into range. Assuming that ETH falls back within the range at some point and continues to fall below $2,817.50, the LP position will be composed entirely of ETH.
Thus, in the case of an ETH bull market, LP loses exposure to price increases, and in the case of a bear market, LP gets 100% exposure to downside risk. Assuming a price lag between the centralized exchange and Uniswap, arbitrageurs will squeeze LP.
Bigger LP losses?
While it is too early to tell, as a rule of thumb we can look at how much of the trading volume in v3 vs v2 comes from the top ranked arbitrage bots and we assume that more bot activity means greater LP losses.
As the table below shows, the largest bots account for 15.5% of the total Uniswap v3 trading volume since inception! This address alone has generated $3 billion in trading volume since the launch of v3. In addition, the top 5 arbitrage bots account for approximately 22% of total volume, much larger than the level of v2. During the same period, the top 5 arbitrageurs accounted for approximately 11.2% of total volume.
It also shows the significant losses LP suffered early in v3. But why is there such a big difference relative to v2?
While the uniform XYK pricing curve implemented in v2 is not the most capital efficient solution, it still provides some level of protection for LPs as the slippage increases exponentially. Therefore, even if v2 tokens are mispriced, it is unlikely that underpriced tokens will flow out of the pool. On the other hand, unless v3 LPs aggressively adjust their price ranges, they risk losing their exposure to underpriced assets altogether, or having positions composed entirely of overpriced assets that become the preserve of arbitrageurs.
Top 5 robot trading volume share by activity; Source: https://duneanalytics.com/queries/51508/101777
What is the future?
We expect arbitrage participation to diminish over time in v3 for the following reasons.
LPs have a better grasp of risk with the lessons learned from the past
Further specialization of liquidity provision with more LPs utilizing dedicated vaults for active management (https://alpha.charm.fi/)
Layer 2 deployments and a low Gas fee environment support more aggressive LP strategies
Potential MEV-proof strategies that can benefit traders with less slippage and lower gas losses
Uniswap V3 is off to a good start. Despite the areas for continuous improvement, we remain optimistic about the future of V3. Eventually we will see more professional market makers become liquidity providers, squeezing out arbitrageurs with better pricing. And passive liquidity will become a thing of the past, provided only through dedicated vaults. Overcoming the current drawbacks will require an ecosystem layer of liquidity yield management, including dApps like Alchemist, Charm and Visor, which will support DeFi products to take them to the next level.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/uniswap-v3-towards-capital-efficient-or-amplified-lp-losses/
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