It’s finally here! A comprehensive explanation of the new features of Uniswap V3

introduce

What is the long-awaited Uniswap V3 all about? How is it different from V2? Will it be a game-changer in the field of automated market makers? Will it be launched directly on Layer 2? You will find the answers to these questions in this article.

Uniswap

Although Uniswap, as one of the core projects of DeFi, does not need too much introduction, before entering V3, let’s 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 gain interest from users.

In May 2020, at the beginning of the DeFi summer, Uniswap launched the second version of the protocol, called Uniswap V2.

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

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

Less than a year since its launch, V2 has already facilitated over $135 billion in trading volume — a staggering figure that rivals the top centralized cryptocurrency exchanges.

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

V3

Just before launching V2, the team behind Uniswap had already started working on a new version of the protocol, details of which were just announced at the end of March 2021. The team decided to launch Uniswap V3 simultaneously on the Ethereum mainnet and Optimism (an Ethereum second-layer scaling solution), with the goal of launching it in early May.

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

So what are the main changes?

Compared with V2, Uniswap V3 focuses on maximizing capital efficiency. This not only allows LPs to earn higher returns on capital, but also significantly improves transaction execution, which is now comparable to or even exceeds centralized exchanges and AMMs focused on stablecoins.

In addition to this, LPs can create overall portfolios that significantly increase exposure to preferred assets and reduce their downside risk due to greater capital efficiency. They can also add a single asset as liquidity at a price range above or below the current market price, which essentially creates a fee-based limit order that is executed along a smooth curve.

This can all be achieved by introducing the new concept of concentrated liquidity.

In addition to this, V3 introduces multiple fee tiers and improves Uniswap Oracles.

Now, let’s go through some of the features of Uniswap V3 one by one to understand them better.

Concentrated Liquidity

Centralized liquidity is the main concept of V3.

When LPs provide liquidity to a V2 pool, the liquidity is evenly distributed along the price curve. While this can handle all price ranges between 0 and infinity, it makes capital quite inefficient. This is because most assets typically trade within a certain price range. This is especially noticeable in pools with stable assets, which trade in a very narrow range. For example, Uniswap’s DAI/USDC pool only spends about 0.5% of its funds on trades between $0.99 and $1.01 - the vast majority of trading volume is in this price range. This is also the trading volume that earns LPs most of their trading fees.

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

In V3, LPs can select a custom price range when providing liquidity, allowing funds to be concentrated in the range where the majority of trading activity occurs.

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

Prior to V3, the only way to allow LPs to have personal curves was to create a separate pool for each curve. If these pools were not aggregated together, a transaction would have to be made in multiple pools, resulting in high gas costs.

What is important is that users trade against the combined liquidity at a certain price point, which comes from all overlapping price curves at that specific price point.

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

Capital efficiency

Pooled liquidity provides LPs with better capital efficiency.

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

Alice and Bob both decide to provide liquidity in the Uniswap V3 ETH/DAI pool. They each have $10,000 and the current price of ETH is $1,750.

Alice divides her entire capital between ETH and DAI and makes a deposit at any price range (similar to V2), she deposits 5,000 DAI and 2.85 ETH.

Instead of using all of his capital, Bob pools his liquidity and offers it in the price range of 1,500 to 2,500. He deposits 600 DAI and 0.37 ETH, totaling $1,200, and keeps the remaining $8,800 for other purposes.

Interestingly, they both earn the same transaction fees as long as the ETH/DAI price stays within the range of 1500 to 2500. This means that Bob only needs to provide 12% of Alice’s funds to earn the same return, making his funds 8.34 times more efficient than Alice’s funds.

Most importantly, Bob has reduced the risk of his overall capital. The probability of ETH falling to $0 is very small, and if it does happen, Bob and Alice's liquidity will all become ETH. Although they will both lose their entire capital, Bob will bear much less risk.

LPs in more stable pools are most likely to provide liquidity in a narrow range. If the current $25 million DAI/USDC pool in Uniswap v2 is concentrated in the 0.99 - 1.01 price range in v3, as long as the price stays in this range, it will provide the same depth as the $5 billion in Uniswap v2.

When V3 launches, maximum capital efficiency will be 4,000x compared to V2. This is achievable when providing liquidity within a single 0.1% price range. Beyond this, the V3 pool factory will be able to support a granularity range of 0.02% - this equates to up to 20,000x capital efficiency relative to V2.

Active liquidity

V3 also introduces the concept of active liquidity. If the price of an asset traded in a particular liquidity pool moves outside the LP's price range, the LP's liquidity is effectively removed from the pool and stops earning fees. When this happens, the LP's liquidity shifts entirely to one of the assets, and they end up holding only one of them. At this point, the LP can wait for the market price to return to their specified price range, or they can decide to update their range with the current price in mind.

While it is possible that there is no liquidity in a particular price range, in reality, this will create a huge opportunity for LPs to actually provide liquidity for that price range and start collecting all trading fees. From a game theory perspective, we should be able to see a reasonable allocation of capital, with some LPs focusing on narrow price ranges, others focusing on relatively less narrow but more profitable ranges, and others choosing to update their price ranges when prices move out of previous ranges.

Range Limit Orders

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

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

This feature, when used with a narrow range, can achieve a similar goal as a standard limit order (setting a specific price).

For example, let's assume that DAI/USDC is trading below 1.001. LPs can decide to deposit their DAI in a narrow range between 1.001 and 1.002. Once DAI trades above 1.002 DAI/USDC, the entire LP's liquidity will be converted into USDC. At this point, LPs must withdraw their liquidity to avoid automatic conversion back to DAI once DAI/USDC goes back below 1.002.

Long Position

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

- $2,000 of liquidity placed in the price range of ($1,500-$2,500)

- $1,000 of liquidity placed in the price range of ($2,000-$3,000)

- $500 of liquidity placed in the price range of ($3500-$5000)

The ability to enter multiple LP positions at different price intervals, approximating any price curve or even an order book, allows for the creation of more complex market making strategies.

Non-fungible 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 LP token.

Instead, provided liquidity is tracked by non-fungible ERC721 tokens. Nevertheless, LP positions that appear to fall within the same price range will be represented by ERC20 tokens through peripheral contracts or through other cooperative agreements.

In addition, transaction fees no longer represent LPs automatically reinvesting into the liquidity pool. Instead, peripheral contracts can be created to provide such functionality.

Flexible Fees

The next new feature is flexibility in terms of trading fees. Instead of offering the standard 0.3% trading fee in Uniswap V2, V3 initially offers 3 separate fee tiers - 0.05%, 0.3%, and 1%. This allows LPs to choose pools based on the risk they are willing to take. The team behind Uniswap expects that the 0.05% fee will be used primarily for pools with similar assets, such as different stablecoins, 0.3% for other standard pairs like ETH/DAI, and 1% for more pairs in different fields.

Similar to V2, V3 will also implement a protocol fee switch, where a portion of the transaction fees will be transferred from LP to UNI token holders. Instead of having a fixed percentage like V2, V3 will provide 10 to 25% of LP fees on a per-pool basis. This will be turned off at launch, although it can be turned on at any time according to Uniswap management.

Advanced Oracles

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

In addition to this, the cost of keeping the oracle updated has been reduced by around 50% compared to V2.

These are pretty much all the main features of Uniswap V3.

Interestingly, all these features do not result in an increase in gas fees. On the contrary, the most common function - simple transactions will be about 30% cheaper than their V2 equivalents.

Summarize

It looks like Uniswap V3 could be a game changer in terms of AMMs. It essentially combines the benefits of standard AMMs and stable asset AMMs to make capital more efficient. This makes V3 a super flexible protocol that can accommodate a range of different assets.

It will be interesting to see how V3 affects other AMMs, especially those that V2 was unable to compete with in the early days, such as stablecoin AMMs like Curve.

The simultaneous launch of V3 on Optimism is also critical.

Optimism is a Layer 2 scaling solution based on optimistic rollup that enables fast and low-cost transactions without sacrificing Layer 1 security. Currently, Optimism has been partially launched and has begun integration with a few selected partners such as Synthetix.

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

The ability for exchanges to withdraw assets to Optimism will be another big step towards the rapid adoption of V3 on Layer2.

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

Beyond that, the V2 to V3 migration will be done on a completely voluntary basis. In the case of the V1 to V2 migration, it took V2 just over 2 weeks to surpass V1’s liquidity. It would also be interesting if Uniswap’s governance decides to further encourage LPs by voting to add some kind of V3-only incentive — perhaps another liquidity mining program.

With V3’s ultra-high capital efficiency, even if the existing liquidity is divided among V2, V3, and V3’s Optimism, it should be enough to facilitate low-slippage trading across all 3 protocols.

One challenge with V3 is that providing liquidity may become a bit difficult, especially for less sophisticated users. Choosing the wrong price range may amplify the effects of impermanent loss. Perhaps in the future there will be third-party services that can help users choose the best strategy for allocating liquidity.

So what do you think of Uniswap V3? Will it be a game changer in the AMM space? Will Optimism’s Uniswap bring more users to DeFi? (Screen)