Analysis of Uni V3: What changes will the aggregation liquidity function bring to LP

Original title: What changes will the aggregation liquidity function bring to LP | Uniswap V3 New Features Analysis Series 1

As the absolute leader in the DEX market, Uniswap's V3 version has attracted widespread attention from the market once it was released. The new version focuses on improving the market-making function and improving the efficiency of liquidity provider (LP) capital use. So, for LPs who are already familiar with the V2 mode, what changes will the V3 version bring to them.

We know that in the Uniswap V2 version, the liquidity provided by all LPs is evenly distributed on a curve defined by x*y=k. Regardless of the size of the fund pool, this curve can fully represent all possible prices and provide unlimited liquidity to the market. However, the uniform distribution of funds also greatly reduces the efficiency of LP market making. Especially when it comes to stablecoin trading pairs, about 99% of the liquidity in the fund pool has never been effectively utilized. Moreover, the inefficient transaction curve also gives Swap, which focuses on stable coins such as Curve, room to survive and develop.

The total transaction volume of Uniswap NFT aggregation services exceeded 2 million US dollars, with a weekly growth of over 100%: Jinse Finance reported that according to the latest data from Dune Analytics, the total transaction volume of Uniswap NFT aggregation services has exceeded 2 million US dollars, reaching 2,181,238 US dollars so far, with a total transaction volume of 3,292 Pen. Currently, the platform with the highest transaction volume in the Uniswap NFT aggregation service comes from OpenSea, and the top three NFT series by transaction volume are: "Mutated Ape" MAYC ($268,809), CLONEX-X TAKASHIMURAKAMI ($207,850), "Bored Ape" Bored Ape Kennel Club ($136,232). Historical data shows that the UniSwap NFT transaction volume exceeded 1 million US dollars on December 7, which means that this indicator has increased by more than 100% on a weekly basis. [2022/12/19 21:53:22]

The new version is finally going to solve this problem.

Security Team: Changpeng Zhao may have misreported the Uniswap protocol vulnerability: Jinse Finance reported that according to PeckShield’s official social media, according to the company’s preliminary investigation, Changpeng Zhao may have misreported the Uniswap protocol vulnerability. normal operation. [2022/7/12 2:07:04]

In the V3 version, LPs will be able to actively choose the range of market making according to their own expectations of price trends. The mathematical formula can be expressed as follows:

x*y=k(price: P=x/y, P∈[price lower limit, price upper limit])

It can be seen that the new liquidity provision method still uses the original simple price curve, and the change is only reflected in the limited value range of the price P. It is equivalent to artificially intercepting a line segment on the original price curve. The new market-making method enables LP's funds to be completely aggregated within the selected curve range. If the subsequent price trend meets LP's expectations, LP will thus obtain more fee income. Especially for stable currency trading pairs, assuming that the relative price fluctuation of the two currencies does not exceed 0.1%, then according to the official introduction of Uniswap, in an ideal state, through the concentration of liquidity, the fee income earned by LP with the same funds will 4000 times that of the previous version.

Umbrella Network announced the launch of the Uniswap liquidity pool reward plan: According to the official Medium blog, the oracle project Umbrella Network announced the launch of the liquidity pool reward plan, which will distribute 20,000 UMB to UMB/ETH liquidity providers on Uniswap every month Tokens, liquidity must remain in the system for at least 30 days to be rewarded. The rewards program will begin March 1 and run indefinitely until further notice. [2021/3/1 18:04:58]

(Quoted from Uniswap v3 Core)

Although only a small adjustment has been made on the original curve, the V3 version will bring great changes to LP's market-making habits. It will be difficult for LPs to make market according to the familiar 50%-50% ratio.

UNI’s 24-hour increase of 30.66%: According to Gate.io Zhima Kaimen market, as of 15:10 today, UNI 24H’s highest increase was 30.66%, and the current increase is 19.75%. The 24H highest price is 12.890 US dollars. Recently, the market has fluctuated greatly, please pay attention to controlling risks. [2021/1/25 13:26:10]

We know that in the classic V2 version, LP will provide two tokens for market making at the same time, and the value of the two tokens must be equal, which is also summarized by many people as the 50% market making principle. In the new V3 version, this process has become much more complicated.

In order to better illustrate the changes in the V3 version, we will take the ETH-USDC trading pair as an example for analysis below.

Scene one

The spot price of ETH is $2,000, and LP expects that the price of ETH will fluctuate sideways in the range of $1,900-$2,100, so they decide to make a market in the range of $1,900-$2,100 to earn fees.

According to the new algorithm of V3, LP will need to pay the equivalent of ETH and USDC liquidity to the agreement, such as 5 ETH and 10,000 USDC, with a total market value of 20,000 US dollars.

It can be seen that since the spot price is exactly at the middle point of the market-making price range, there is no obvious difference between the market-making operation in V3 and the V2 version in this scenario.

Scene two

The spot price of ETH has risen to 2300 US dollars, and LP still hopes to make a market in the range of 1900-2100 US dollars. Since the spot price is already higher than the upper limit of the price range selected by LP at this time, LP will have to use USDC for market making at this time.

Of course, since the spot price is higher than the market-making price range, LPs will not be able to obtain handling fees at this time. Only after waiting for the price of ETH to gradually drop below $2,100, will the LP’s market-making funds be gradually converted from USDC to ETH and start accumulating fee income.

Scene Three

The spot price of ETH has dropped to $1700, and LP still hopes to make a market in the range of $1900-2100. I think readers can already see that at this point LP needs to provide liquidity to the protocol in ETH. Wait until the ETH price rises to $1900 before you can start earning fee income.

It can be seen that the currency composition of LP's investment in market-making funds depends on the relative position of the spot price and the market-making price range. If the spot price is outside the market-making price range, LPs must all make markets in a single currency.

If the current price is within the market-making price range, LP needs to provide two currencies for market-making. The specific calculation process is more complicated, so I will not introduce it here.

After reading this, some readers may already want to ask, does it mean that we can already realize unilateral market making on V3?

In my opinion, it cannot be understood in such a simple way. Unilateral market making often means that what currency you deposited when making the market will still be the same currency when you withdraw it. In the V3 version, although in some special cases, LP can make a market in a single currency, but when withdrawing liquidity, the ratio of the two currencies will depend entirely on the spot price at the point of withdrawal.

We continue to analyze the setting in Scenario 2. If the price of ETH has dropped to $2,000 when LP withdraws liquidity, LP will get half of ETH and half of USDC. If the price drops to $1,700 when withdrawing, all the funds that LP withdraws will be in ETH.

Perhaps you have already felt that in the V3 version of market making, LP will bear more risks of currency changes. In the words we are more familiar with, the impermanent loss borne by LP has become larger. This topic is very important, and we will analyze it in detail in subsequent articles.

From the above analysis, it can be seen that making a market in V3 is no longer a simple operation like making money without thinking in V2. If you want to become a V3 LP, you first need to have a clear expectation of the price trend, and at the same time adjust your market-making positions in a timely manner according to market changes. All of these will make LP a job that requires more professional knowledge.

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