What is going on with the long-awaited UniswapV3? How is it different from V2? In the field of automated market makers, will it become a game-changing product?

Uniswap

Although Uniswap, as one of the core projects of DeFi, does not require much introduction, before entering V3, let us quickly understand a few key points.

Uniswap is essentially a protocol for decentralized, permissionless token exchange on the Ethereum blockchain. The initial version of Uniswap was launched in November 2018 and slowly began to arouse user interest.

In May 2020, at the beginning of the DeFi summer, Uniswap launched the second version of the agreement called Uniswap V2. The main feature is that on the basis of the ERC20-ETH pool existing in V1, the ERC20/ERC20 liquidity pool is added.

In the second half of 2020, Uniswap V2 experienced a parabolic growth and quickly became the most popular application on Ethereum. It has also almost become the standard for automated market makers (AMMs) and has become one of the most forked projects in the entire DeFi field.

In less than a year since its launch, V2 has contributed to more than $135 billion in trading volume-an astonishing number, comparable to top centralized cryptocurrency exchanges.

V3

Just before the release of V2, the team behind Uniswap has begun to develop a new version of the agreement, the details of which were just announced at the end of March 2021. The team decided to simultaneously launch Uniswap V3 on the Ethereum mainnet and Optimism (a second-layer expansion solution for Ethereum), with the goal of launching in early May.

This is obviously one of the most anticipated announcements in DeFi history, and it seems that V3 can completely change the field of AMM.

So what are the main changes?

Compared with V2, Uniswap V3 focuses on maximizing capital efficiency. This not only allows LPs to earn a higher return on capital, but also greatly improves transaction execution, which is now comparable to or even surpassing centralized exchanges and AMM, which focuses on stablecoins.

In addition, due to higher capital efficiency, LPs can create an overall investment portfolio, significantly increase their exposure to priority assets and reduce their downside risks. They can also increase a single asset as liquidity in a price range higher or lower than the current market price, which can basically create a charge limit order executed along a smooth curve.

All of this can be achieved by introducing a new concept of concentrated liquidity.

In addition, V3 also introduced multiple charging levels and improved Uniswap Oracles.

Now, let's take a look at some of the features of Uniswap V3 one by one in order to understand them better.

Concentrated Liquidity (Concentrated Liquidity)

Concentrated liquidity is the main concept of V3.

When LP provides liquidity to the V2 pool, the liquidity is evenly distributed along the price curve. Although this can handle all price ranges between 0 and infinity, it makes capital very inefficient. This is because most assets are usually traded within a certain price range. This is especially evident in pools with stable assets, which have a very narrow trading scope. For example, Uniswap's DAI/USDC pool only spent about 0.5% of its funds for transactions between US$0.99 and US$1.01-most of the trading volume was conducted in this price range. This is also the transaction volume that earns most of the transaction fees for LPs.

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

In V3, LP can choose a custom price range when providing liquidity, allowing funds to be concentrated in the range where most trading activities occur.

To achieve this goal, V3 creates a personalized price curve for each liquidity provider.

Before V3, the only way to allow LPs to have individual curves was to create a separate pool for each curve. If these pools are not put together, a transaction must be carried out in multiple pools, which will result in high gas costs.

What is important is that users need to trade for a combination of liquidity at a certain price, which comes from all overlapping price curves at this specific price.

The transaction fees earned by LPs are proportional to their liquidity contribution within a certain range.

Capital efficiency

Centralized liquidity provides LPs with better capital efficiency.

Let's quickly go through an example to better understand it:

Both Alice and Bob decided to provide liquidity in the ETH/DAI pool of Uniswap V3. Each of them has $10,000. The current price of ETH is $1,750.

Alice allocates all her capital between ETH and DAI, and deposits funds in any price range (similar to V2). She deposits 5,000 DAI and 2.85 ETH.

Instead of using all of his capital, Bob pooled his liquidity and provided it in the price range of 1,500 to 2,500. He deposited 600 DAI and 0.37 ETH for a total of $1,200, and kept the remaining $8,800 for other purposes.

Interestingly, as long as the ETH/DAI price stays in the range of 1500 to 2500, they can all earn the same transaction fees. This means that Bob only needs to provide 12% of Alice's funds to get the same return, which makes his fund efficiency 8.34 times that of Alice's funds.

Most importantly, Bob reduces the risk of his overall capital. It is very unlikely that ETH will fall to $0. Assuming this is the case, all of Bob and Alice's liquidity will become ETH. Although they will all lose all their capital, Bob's risk is much smaller.

The LP in a more stable tank is most likely to provide liquidity in a narrow range. If the DAI/USDC pool currently worth 25 million US dollars in Uniswap v2 is concentrated in the 0.99-1.01 price range of v3, as long as the price stays within this range, it will provide the same depth as the 5 billion US dollars in Uniswap v2.

When V3 is launched, the maximum capital efficiency will reach 4000 times compared with V2. This is achievable when liquidity is provided within a single 0.1% price range. In addition, the V3 pool factory will be able to support a granularity range of 0.02%-relative to V2, which is equivalent to a capital efficiency of up to 20,000 times.

Range Limit Orders

Range limit orders are the next feature enabled by centralized liquidity.

This allows LPs to provide a single token as liquidity within a custom price range higher or lower than the current market. When the market price enters the specified range, one asset will be sold to another asset along the smooth curve-while still earning swap fees in the process.

When this function is used with a narrow range, it can achieve a similar goal (setting a specific price) as a standard limit order.

For example, let's assume that the transaction price of DAI/USDC is lower than 1.001. The LP can decide to store its DAI in a narrow range between 1.001 and 1.002. Once the DAI transaction is higher than 1.002 DAI/USDC, the liquidity of the entire LP will be converted into USDC. At this time, LPs must withdraw their liquid funds to avoid automatic conversion back to DAI once DAI/USDC returns below 1.002.

Long position

LPs can also decide to provide liquidity in multiple price ranges, which may or may not overlap. For example, LP can provide liquidity for the following price ranges of the ETH/DAI pool:

• The liquidity of $2000 is placed in the price range ($1500-$2500)

• The liquidity of USD 1,000 is placed in the price range (USD 2,000—USD 3,000)

• The liquidity of 500 US dollars is placed in the price range of (3500 US dollars-5000 US dollars)

Ability to enter multiple LP positions in different price ranges, which is similar to any price curve or even an order book, which can create more complex market-making strategies.

Non-homogeneous liquidity

Since each LP can basically create its own price curve, the liquidity position is no longer fungible and cannot be represented by the well-known ERC20 LP token.

Instead, the liquidity provided is tracked by non-homogeneous ERC721 tokens. Nevertheless, it seems that LP positions in the same price range can be represented by ERC20 tokens through external contracts or through other cooperation agreements.

In addition, transaction fees no longer represent the automatic reinvestment of LP into the liquidity pool. Instead, peripheral contracts can be created to provide such functions.

Flexible fee

The next new feature is flexibility in terms of transaction fees. V3 does not provide the standard 0.3% transaction fee in Uniswap V2, but initially provides three independent fee levels-0.05%, 0.3% and 1%. This allows LPs to choose the pool of funds based on the risks they are willing to take. The team behind Uniswap expects that 0.05% of the fee is mainly used for pools with similar assets, such as different stablecoins, 0.3% for other standard currency pairs such as ETH/DAI, and 1% for more currency pairs in different fields.

Similar to V2, V3 can also implement protocol fee switching, and part of the transaction fee will be transferred from LP to UNI token holders. V3 does not have a fixed percentage like V2, but provides 10 to 25% of LP fees on a per pool basis. This will be closed at launch, although according to Uniswap management, it can be opened at any time.

Advanced oracle

Finally, there is a major improvement to the TWAP oracle introduced by Uniswap V2. V3 can calculate all the most recent TWAPs in the past about 9 days in one on-chain call.

In addition, compared with V2, the cost of keeping the oracle updated is reduced by about 50%.

These are almost all the main functions of Uniswap V3.

Interestingly, all these functions did not cause an increase in gas fees. On the contrary, the most common function-simple transaction will be about 30% cheaper than its V2 equivalent function.

Summary

It seems that Uniswap V3 can change the rules of the game in terms of AMM. It basically combines the benefits of standard AMM and stable asset AMM to make capital more efficient. This makes V3 a super flexible protocol that can adapt to a range of different assets.

See how V3 will affect other AMMs? Especially in the early stage of V2 that cannot compete with it, such as stable currency AMM like Curve, this observation will be very interesting.

The simultaneous launch of V3 on Optimism is also critical.

Optimism is a layer 2 expansion scheme based on optimistic rollup, which can realize fast and low-cost transactions without sacrificing the security of the first layer. At present, Optimism has been partially launched and has begun to integrate with a few selected partners such as Synthetix.

Layer2's Uniswap should be able to attract more users who are persuaded by Layer1's high gas fee.

The exchange's ability to withdraw assets to Optimism will be another big step for the rapid adoption of V3 in Layer 2.

On the basis of the launch of V3, the upcoming full launch of Optimism is another event worth looking forward to.

In addition, the migration from V2 to V3 will be carried out on a completely voluntary basis. In the case of the migration of V1 to V2, V2 surpassed the liquidity of V1 in just over two weeks. If Uniswap's governance decides to further encourage LPs, by voting to add some kind of incentives only available in V3-perhaps another liquid mining plan, it would also be very interesting.

With the ultra-high capital efficiency of V3, even if the existing liquidity is divided by the Optimism of V2, V3 and V3, it should be sufficient to facilitate the low slippage transactions of these three agreements.

One of the challenges facing V3 is that providing liquidity may become a little difficult, especially for less mature users. Choosing a wrong price range may magnify the impact of impermanence losses. Maybe there will be third-party services in the future, which can help users choose the best strategy for allocating liquidity.