Byte and Benedict Zhou, co-founder of crypto asset market maker DeepQuant and developer of DeepGo DeFi, respectively
Uniswap V3 introduces new features: both a new AMM mechanism with a “price scale” and a customized “flex fee” that gives liquidity providers more strategic flexibility. As a quantitative researcher who has been immersed in crypto asset market maker strategies for many years, I found a new era of DeFi in the uneventfulness of Uniswap V3.
From a micro perspective, especially for traditional traders, V3’s granular concept is mediocre and its trading approach is closer to that of a centralized exchange. But in the long run, V3 brings more customizability and composability to investors and greatly expands the boundaries of DeFi investment strategies.
The significance of V3 is to supply more customizable strategies, thus compatible with more investment needs, and the NFT-ized LP Token, which becomes a value unit matching the demand side of small investments with professional team providers, enabling the delivery of value Internet, is the greatest innovation of DeFi today.
Investment has an impossible triangle dilemma in return, risk, and scale. V3 increases the efficiency of capital use and thus returns, yet it also magnifies risk, so it is especially critical to provide external feeding data to Uniswap V3 and use it to achieve risk pricing.
DeFi’s ability to deliver value on a decentralized blockchain is the trend, but it requires the right timing and the right people to really explode. the V3 ecosystem is currently in its gestation period, and more innovative projects will soon emerge that are compatible with it, such as new liquidity gun pools and custom strategy solutions.
The Imagination of NFTized LP Token
In Uniswap V2, after a user adds liquidity, Uniswap returns an ERC20 token to the user, which is called an LP Token, which represents the liquidity provider’s ownership of the liquidity it provides. When users want to redeem their liquidity, they simply destroy their LP Token and receive a share of the corresponding token in the pool.
Since Uniswap V2 uses an overall pool model, LP Token is a standard ERC20 token. In V3, however, each LP creates liquidity based on a different price range, so the liquidity provided is in ERC721 tokens as warrants, and Uniswap issues customized NFT cards for each liquidity provider.
This simple NFT card represents a unit of value that carries the liquidity provider’s time cost, risk cost, and strategy value. In the evolution of the Internet, the standardization of value units has laid the cornerstone of various Internet platforms, such as Amazon’s commodity links and Instagram’s images. Now the blockchain world is just like the Internet in 2003-2004, it is on the eve of the explosion. The perfection of value unit will allow the standardization of users to grow rapidly and eventually form the network scale effect.
The essence of LP Token of NFT is asset securitization. As a financial tool, asset securitization was originally designed to improve the allocation of resources and increase the efficiency of capital operation. In traditional finance, the opaqueness of asset securitization has been criticized for the potential risk of loss of control. But in a decentralized world, the trusted value of blockchain dramatically eliminates such concerns.
Decentralized Liquidity Machine Gun Pool
Uniswap V3’s granularity has led to more customized strategies, creating a liquidity pool market.
In the short term, the decentralized liquidity machine gun pool project has tremendous value to the demand side of investment, while in the long term it has positive feedback incentive benefits to the supply side of assets, the core of which lies in the data algorithm between supply and demand. The data feedback helps to form a benign curation market, where high-quality and robust strategies are sorted and screened, and high-risk and low-return strategies are quickly filtered and eliminated, so that efficient allocation of resources can be achieved.
With the synergy of the innovative machine gun pool project, Uniswap V3 will be constructed into a more stable derivative system to cushion the risk of malicious collapse of the project side and further protect the interests of investors. the underlying asset corresponding to LP Token is a combination of base tokens and project tokens. This means that the rate of change in the value of the pledged assets will be reduced in the event of severe market volatility, thus achieving a liquidation buffer.
Impossible Triangle Conundrum
Uniswap V3 introduces mechanisms such as “centralized liquidity”, “rate customization”, “range orders” and “non-homogenized positions”, all for the purpose of improving capital efficiency. While helping liquidity providers to avoid unpredictable losses and generate higher returns as much as possible, it also inevitably increases risk. In the classical laws of investment trading, increasing return, reducing risk, and increasing scale are impossible triangular puzzles, and all three are difficult to achieve at the same time.
In Uniswap V3, the liquidity provider yield is significantly higher, however, the capital risk is significantly higher. Especially in extreme market conditions, when the price of an asset class in a trading pair goes up and down, and the price exceeds the price range set by the liquidity provider, the liquidity in the range will be drained by market arbitrageurs, and risk control becomes a problem for the liquidity provider.
When the risk of Uniswap V3 cannot be effectively controlled based on its own mechanism, the liquidity provider can only resort to external risk data feeding, at this time, the NFT-ized LP Token will play an important role as a value unit bridging the world outside DEX.
LP Token, as an innovative derivative, also needs to be efficiently utilized; there is a large number of liquidity providers in the DeFi space, but after pledging their trading pairs in the liquidity pool, they only get the one-sided benefit of liquidity mining, and the funds are not fully utilized. The LP Token can be pledged for higher capital utilization.
Uniswap V3+CDO Model
CDO is called Collateralized DEX Offering and was developed by DeepGo team. Users are able to continuously raise funds through risk classification of the underlying pledges. After providing initial liquidity in Uniswap V3, the market maker locks the LP Token as a pledge in the CDO agreement, thus providing continuous liquidity buying.
When Uniswap users provide liquidity in V3 with a large interval, the local currency denominated value of the liquidity underlying is less volatile. The graph below simulates the curve of the overall value of the underlying with the token price after the user pledges the same value of the underlying in the V2 and V3 versions. It is clear that the value curve is smoother in the V3 version.
If a CDO provider pledges LP Token in Uniswap V3, the pledge will be significantly more risk-resistant in extreme market conditions, which will also make the booster pool system more robust: a reasonable risk warning when the project token rises sharply, and a good risk buffer when the token falls sharply. This combination of Uniswap V3 and CDO will ultimately enable high-quality assets to rise in the long run, and bad assets to gradually decay and be retired.
More accurate risk pricing
In the CDO model, in order to achieve more accurate risk pricing, the risk needs to be graded, resulting in a fixed income graded fund. In addition to the originator of the project (IP), two main types of players need to be involved, divided into significant participants (GP) and fixed income earners (LP). Both types of players will provide ongoing capital input to the project, with the GP, as the direct investor in the project, converting all of the principal into project tokens, and the LP’s capital being used as leverage for the GP to help the project achieve greater value growth.
The CDO model allows IP pledges of high quality assets (Uniswap V3 LP Token), which adds a layer of security for GPs and encourages a large inflow of GP capital. Each influx of GP capital is injected into the Vault to house the LP’s risk reserves and profits. As the volume of Vault funds increases, the willingness of LPs to invest is gradually amplified.
LPw ∝ Vault ∝ IPcol * GPturnover * IPltv
GPturnover ∝ GPw
IPcol is the pledge of IP
IPltv is the current pledge rate of IP
GPturnover is the turnover rate of GP
GPw is GP’s willingness to invest
LPw is the LP’s willingness to invest
Vault is the reserve
Thus, through effective signaling, the underlying assets with less volatile IP pledges effectively drive LP funding capacity, and LP funding, as the most important link in the market feedback loop, will have a positive multiplier effect.
If the project is a distressed asset, GP participants will have much higher volatility in the GP’s leveraged underlying than in the IP pledge due to the fact that they have exchanged all of their local currency for project tokens, at which point the GP may be the first to be retired due to the dip in the project asset price. The remaining GPs would prefer to enjoy the pledges after the IP is liquidated, thus reducing the turnover rate. This leads directly to a shrinkage of incremental Vault, which significantly reduces LPs’ willingness to invest and thus allows poor quality projects to be gradually retired.
LPw ∝ IPcol * GPturnover
GPturnover ↓ ⇒ LPw ↓
Such transmission mechanism not only makes the CDO model work well as a scavenger of distressed assets, but also transmits a large amount of effective market information as external feeding data for Uniswap V3 risk pricing, providing decision feedback to investors and liquidity providers.
The Uniswap V3 upgrade may seem like business as usual, but it provides the basis for much innovation in the DeFi application. Now that CEX is in trouble internally and externally, it is a critical time for the rise of DEX, how can DeFi lead the next bull market? The core lies in drawing on the advantages of combinability of traditional finance and creating more easy-to-use and efficient strategic products to achieve financial inclusion on the ground, thus attracting more entrants.
In my previous opinion, Uniswap originally did not have a moat, but V3 came out to provide more combinable solutions. In the world of open finance, the alpha gain brought by V3 will generate many innovative products, thus forming a real head effect, which is its important strategic layout. However, DeFi is a financial inclusion rather than an oligarchy game, how can small investors enjoy the alpha gains that only scientists or giant whales can get through some kind of agreement? This is where we are currently focusing our exploration.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/veteran-market-maker-reviews-uniswap-v3-core-strength-is-providing-combinable-strategies/
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