authors: @verto0912 @jdcook @overanalyser @catjam @Matthew_Graham @Pepperoni_Joe
Summary
With the introduction of concentrated liquidity, Uniswap increased capital efficiency for LPs and unlocked better trade execution for users. Same execution, in terms of price impact, can now be achieved with liquidity pools that are, on average, 4 times smaller. This has significant implications for liquidity mining incentives, which are the biggest expense for Index Coop.
We looked at the impact of Uni V3 on the buyers & sellers of our products, liquidity providers and the Coop itself. For the buyers & sellers, there’s no difference between V2 and V3 in terms of the user experience. For liquidity providers, while managing an LP position in V3 is currently more complicated than in V2, the capital efficiency of V3 should significantly improve execution and lead to higher trading volumes and thus higher fees to LPs. Further, while LPs have a choice to concentrate their liquidity around the current price, they don’t have to do so. It is still possible to provide liquidity across the entire price range, same as in V2. For the Index Coop, V3 allows us to offer the same execution to our customers with an approximately 4x smaller liquidity pool. At that size, around $8m for DPI at the time of writing, LPs will generate trading fees significantly above 30% without any incentives. This would make the DPI pool self-sustaining and meaningfully reduce the biggest expense for the Coop.
Further research can be found below. Based on our assessment, this group recommends the following:
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DPI should be migrated to V3 as trading volume should be sufficient to make the pool self-sustainable without incentives.
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MVI should stay on V2 - there’s not enough volume.
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As for other products:
- FLI products should evolve organically.
- SMI will launch on V3m using Uniswap’s liquidity mining contracts.
- Bankless plan on launching BED on V3
There are several strategies for migrating DPI to V3 and we would like to request community’s feedback on the below options:
- Turn off incentives completely for the V2 pool and actively communicate our thinking to LPs.
- Keep V2 incentives for another month, with a 50% reduction, and actively communicate that rewards will cease after this final period.
- Manually incentivise LPs to migrate through an airdrop.
- Partner with Harvest and provide some incentives to V3 LPs using Harvest’s vaults.
Below is the in-depth research that the team put together.
Intro to Uniswap v3
Uniswap v3 introduces new features to the leading AMM that drives increased capital efficiency for LPs and a better trading experience for users. The core of the v3 update is concentrated liquidity - giving LPs control over what price ranges their capital is deployed as liquidity. Concentrated liquidity immensely increases capital efficiency. Uniswap v3 also introduces flexible fees and range orders, both features that provide a superior experience for Uniswap LPs.
The purpose of this section is to give an overview of the key features introduced by Uniswap v3 - setting a foundation for further discourse on how these updates benefit different users interacting with Uniswap and how the Index Coop should form new liquidity strategies with Uniswap v3.
Concentrated Liquidity
Uniswap v3 revolves around the creation of concentrated liquidity - the allocation of liquidity to specified price ranges. Uniswap v2 does not employ concentrated liquidity, but rather any liquidity deployed to a pool gets evenly distributed across the price range of zero to infinity.
With Uniswap v3, as the price between two assets rises and falls, any liquidity positions with a range that contains current price are considered active and can be traded against. If an LP is maintaining liquidity in a range that does not contain the current price, that liquidity is considered inactive. Concentrated liquidity offers deeper liquidity around the current price between two assets, as LPs are incentivized to keep their liquidity active and earn trading fees.
It is also important to note that concentrated liquidity is non-fungible liquidity. In Uniswap v2, LP tokens are fungible, meaning each token represents an equal unit of liquidity in a pool. Because LPs now deploy concentrated liquidity in v3, this liquidity is considered non-fungible. Each LP’s position is completely unique. LP positions in v3 are represented by ERC-721 tokens (NFTs) rather than ERC-20 tokens.
Capital Efficiency
Not having to deploy capital across the price range of zero to infinity increases capital efficiency. Trading fees earned by LPs are divided proportionally to how much liquidity they provide. In v2, all liquidity is considered equal, thus an LP earns fees proportional to how much of the overall liquidity pool they own. With v3, an LP only earns trading fees when their liquidity is active, and they earn fees proportional to how much of the current active liquidity they own. Essentially, LPs can strategically own higher percentages of active liquidity at any given time, thus earning a higher percentage of the trading fees.
Uniswap has provided a capital efficiency calculator in their blog post to help understand the capital efficiency impact that comes with v3.
Other changes
Flexible fees - Uniswap v3 introduces flexibility into the fee structure at the pool level. Pools can be created with one of three fee levels: 0.05%, 0.30%, and 1% (initially, more can be added by UNI governance over time).
Range orders - Single-sided asset provisioning with Uniswap v3 allows for range orders using the AMM. An LP can provide a single asset to a specified range - as the price moves through that range, the LP’s initial deposit is converted into the secondary asset. The two current possible range order types are take profit orders (“sell the top”) and buy limit orders (“buy the dip”).
Impact of Uni V3 on our stakeholders
In the recent forum post, OA identified three primary stakeholders when it comes to our products. They are:
- Holders, including buyers and sellers
- Liquidity providers
- Index Coop itself
Holders
For holders, the optimal user experience entails the ability to buy or sell our products as close to the NAV as possible with the lowest cost, including gas, slippage and price impact. For this group of people, trading through V3 presents no additional hurdles as the interface is the same.
What about the execution, specifically the price impact? This article from Hasu and Paradigm Research does a good job explaining price impact.
With AMMs, the current market price is “the price the AMM wants for the marginal token. However, in practice, a trader will often buy or sell many tokens at once, with every token costing more than the previous one.
This difference between the current market price and the expected fill price is called ``price impact.”
This is where concentrated liquidity comes in. As mentioned above, concentrated liquidity increases the market depth and therefore reduces price impact. Let’s look at several examples.
From this table, we can see that at smaller pool sizes, execution improves by about 4x.
For more established pairs, that improvement is even more significant. At a pool size of $40m, for example, our exchange issuance and direct mint functionality for large purchases becomes unnecessary. It’s worth noting that the quantum of the improvement depends partially on how liquidity providers choose to concentrate their liquidity and therefore will vary on a case by case basis.
Liquidity Providers
For liquidity providers, the situation is more complicated. We consider them our customers because they:
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hold our products and
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provide the service to the Coop by supplying liquidity for our products.
However, we have established above that holders benefit materially from Uniswap V3. Furthermore, while liquidity remains important, the capital efficiency of Uniswap V3 means that we need much less of it to ensure the same level of customer experience for buyers and sellers.
Looking at this from the perspective of a liquidity provider, Uniswap V3 is certainly less friendly in terms of user experience. It is much more tailored to active management and, as LP positions are represented by NFTs, they are not currently compatible with the rest of the Ethereum ecosystem. There are solutions being developed to address both of these challenges.
At the same time, providing concentrated liquidity increases returns while also enabling range order (ie “sell the top” and “buy the dip”). It’s also worth noting that LPs can still provide liquidity for the entire range, making V3 experience equivalent to V2.
In his post, OA outlined some of the characteristics LPs might look for such as a desirable pair to own long term and high trading fees. Uniswap V3, through concentrated liquidity, increases trading fees an LP can earn while having no impact on the pair one owns. Overall, while migrating to V3 presents a challenge from a user experience perspective, it can be financially beneficial for LPs.
Index Coop
What is the impact of Uniswap V3 on Index Coop itself? From the Coop’s perspective, we care that our customers can buy our products easily, with low friction, as close to the NAV as possible and with the lowest cost, including gas, slippage and price impact. We also care about the financial costs associated with incentivising liquidity to enable that purchase experience.
As discussed above, there is no difference between Uniswap V3 and Uniswap V2 when it comes to the buying or selling experience. However, Uniswap V3 requires much less liquidity, between 3x and 5x less looking at MVI and DPI, to deliver that same experience. At the very least, migrating liquidity to Uniswap V3 should allow us to reduce incentives proportionately.
It is also worth considering the impact of trading fees on the overall rate of return for liquidity providers and therefore, the necessity of further incentives.
We estimate that a $1.5m MVI-ETH pool on Uniswap V3 will match the current execution parameters in V2. So far, we have seen the average volume for MVI at about $175k per day.
That’s $525 in fees for LPs ($175k * 30bps (swap fee)). On a $1.5 million pool, that’s about 13% APR.
What about DPI? We estimate that we need a $13 million DPI-ETH pool on Uniswap V3 that will match the current execution parameters in V2 but let’s assume a $15 million pool. For the last 3 weeks or so, the average volume for DPI has been above $12 million per day. Even at the lowest point, DPI averaged around $5 million per day.
Let’s use different levels of trading volume to estimate trading fees for liquidity providers. At $5 million trading volume, LPs generate $15k per day or about 36.5% APR. At $8 million trading volume it’s 58.4% per year and at $12 million LPs get 87.6% APR just from trading fees.
These scenarios should paint a clearer picture as to the incentives liquidity providers would receive in Uniswap V3 without any support from Index Coop and enable us to consider if additional incentives are necessary.
Quick note on automated liquidity management solutions
A number of protocols are working on automated liquidity management tools, including BOA, Xtoken, Stakewise, Gelato, Lixir finance, Visor Finance, Charm finance, Unipilot and Harvest finance. However, we believe that it will take several months for these solutions to be properly tested and therefore safe for us to implement.
Harvest Finance is the only option worth considering at this time. At the time of writing, they had 7 vaults running correlated and uncorrelated pairs with ~$12 m AUM. Structurally, Harvest vaults work by creating a single LP position where users can deposit funds. If market price moves out of the range, then a new NFT is created. Harvest has the ability to add rewards, FARM token is in DPI and the protocol has been around for almost a year.
