Uniswap V3’s AMM revolution sets the stage for DeFi’s next big liquidity shift
The potential of Uniswap V3 has yet to be realized. Passive, simple liquidity positions still dominate, and most positions are managed haphazardly and suboptimally. This is a great opportunity to build new automated strategies that help users proactively manage their liquid assets and create a hot market for everyday DeFi users. Their success is inseparable from the success of UNISWAP itself.
The advantages of AMM
AMM automated market makers introduced the concept of“Lazy market-making”, completely overturning the traditional market-making model. The assets in DeFi are placed in contracts called“Liquidity pools”, through which various traders can trade. This automatic behavior is determined by the asset prices in AMM according to predefined mathematical formulas. One of these formulas is UNISWAP’s constant product Formula X * y = k, where x and Y represent the reserves of two tokens in the pool, respectively, and the multiplication of the two tokens must always be equal to the constant k.
Many stablecoins are much more liquid on UNISWAP V3 than on a centralized exchange. For the USDC/USDT, Uniswap V3 is about five times more liquid than the ANN. UNISWAP V3 also has a higher market depth at all price levels, which means that it is more beneficial for users to execute larger transactions on UNISWAP V3 than on a centralized exchange. For example, for the ETH/USD transaction size of $5 million, the cost savings are approximately $24,000, given the expected price impact variance.
The traditional market structure is dominated by a small number of market makers. However, the simple model of liquidity creation greatly reduces the barriers to creating and participating in markets. This unlocks new and existing forms of value for communities and individuals. UNISWAP V3 significantly improved the AMM model. It increases customizable liquidity positions by allowing users to pool assets within a preset price range. A single V3 liquidity position can be thought of as AMM of X * y = k, but it only applies to a set price range.
The death of traditional market makers
The traditional financial market maker doesn’t just mean the equation X * y = K. In traditional central limit order book (Clob) markets, market makers specialize in placing buyer and seller orders. When a user trades on FTX, the counterparts may not be the target trader, but the market maker. Most high-frequency trading firms, and even banks, allocate a portion of their portfolios to market-making activities. Prominent market makers include Two Sigma, Citadel and Jump Trading.
Market makers are particularly important in traditional markets because directional traders alone cannot provide sufficient liquidity to the market. This is due to the following reasons: 1) There is fragmentation of information. Buyers can not communicate effectively with sellers, especially when dealing in long-tail assets. 2) Some market participants demand that trades be executed immediately, but in practice they take time to execute. 3) Liquidity is subject to asymmetric market sentiment, increasing in a bull market and drying up in a bear market. This is reflected in the dollar value of the outstanding position in the Derby options. 4) the downside of block trading is high.
These problems mask price discovery and increase market volatility, often making markets less efficient. In DeFi, the lack of liquidity from market makers explains why the price of newly issued tokens is so volatile. Defi’s market makers benefit from transaction costs and liquidity incentives. This is much different from traditional market makers who profit from the bid-ask spread (the difference between a buy order and a sell order) . DEFI revenues come with risks. DEFI users fear volatile losses, while traditional market makers try to reduce the risk of asset prices changing over time.
Market makers have traditionally been a complex business, with institutions competing in a variety of ways. They constantly adjust spreads and trading volumes, buy hedging instruments from the derivatives market, and execute light-speed orders on low-latency software. Therefore, it is very difficult for an individual trader to make a market in a central limit market. While there are programs to help retail investors do this, institutional organizations have the advantage of scale in almost every respect.
Why Uniswap is the most promising DeFi exchange
Uniswap is DeFi’s flagship product. The Uniswap V3 is reminiscent of a Silicon Valley marketing strategy. Uniswap founder Hayden Adams made a big splash on Twitter prior to the launch. While this does bring a lot of attention to V3, it also shows that the governance of the protocol is very centralized. The community never participated in the production of V3. No one had the opportunity to raise any legitimate concerns about the new system.
UNI token holders also did not vote on whether to implement the changes. Uniswap has announced that it will not reallocate any fees to UNI holders, but in theoretically the fee conversion can still be turned on at any time. This fee conversion distributes a portion of the protocol cost to UNI token holders. It is also important to note that Uniswap has received significant investment from some of Silicon Valley’s largest investors. Andreessen Horowitz is a major investor in Uniswap Series A, but they are certainly not alone: Union Square Ventures, Paradigm, and many other companies are major stakeholders in Uniswap.
These investors represent a significant portion of all UNI tokens, so they hold the key to the governance of one of the most valuable DeFi projects. The latest version of Uniswap is extremely capital efficient and technically represents an incredible innovation in the AMM space. But it raises the important question of when improvements in protocol efficiency outweigh the importance of bottom-up governance, community building, and protecting the interests of ordinary users?
Uniswap’s V 3 is the most obvious sign of this change in direction. Although UNISWAP’s code can be seen by anyone, it now holds the copyright for the next two years. Open source has been a factor behind the DeFi exponential growth, but for UNISWAP, that phase is over.
The Battle of the liquidity king, the starting point of the next cycle
Liquidity plays an important role in DeFi. So how exactly do automated market makers get liquidity? A common approach is to encourage users of AMM platform to lend out crypto assets in exchange for the opportunity to earn passive income. This means that anyone with cryptocurrencies can lend them to the right liquidity pool and earn some decent returns for their troubles. Attracting as much liquidity as possible is important because it minimizes the slippage caused by large orders.
So what is slippery? Slippage is when there is a high volume of transactions but not enough liquidity to support them. This is a change in asset prices caused by a trade order-a change that can be significant if the order is too large compared to the liquidity pool. Of course, the slippage problem is not unique to automated market makers, and it can also affect order exchanges. However, AMM may be particularly vulnerable because its price adjustment algorithm is based on ratios between assets in the liquidity pool. Thus, higher liquidity means less price volatility.
Another way to reduce the effect of slippage is through the algorithm itself. As we mentioned above, the X * y = k formula is popularized by industry giant Uniswap, but it’s not the only possible way. For example, Curve Finance is an AMM similar to Uniswap, but for stablecoins it uses a more complex formula to meet its specific needs.
Another problem with the AMM design is the so-called contingent loss, which affects the liquidity provider (LP) . Placing assets in a liquidity pool is usually motivated by the prospect of generating passive income in the form of a percentage of the total transaction costs accumulated by the pool. However, due to the vagaries of loss, this proposition is sometimes less profitable than it seems. Since the liquidity pool’s price adjustment algorithm only focuses on the balance between the asset values in the pool, the same token may have different values in the liquidity pool and outside. This means that taking users’ assets out of the liquidity pool can cause losses. Of course, such a loss would only occur if the user took the asset out of the pool, but refusing to do so would limit the user’s ability to profit from other profitable opportunities.
One of the latest trends in AMM’s development is the concentration of liquidity. This feature is designed to increase the efficiency of the price adjustment mechanism, minimize slippage and allow liquidity providers to earn higher fees. Centralized liquidity allows LP to allocate assets to specific price ranges. By combining multiple concentrated liquidity positions, LPs are able to create individual price curves and customize them to its liking. This also allows them to earn transaction fees based on the liquidity provided by a particular price range rather than the total pool liquidity.
Focused Mobility is one of the highlights of Uniswap’s latest release, Uniswap V3. The trading volume generated by Uniswap V3 is comparable with or greater than some major centralized exchanges. AMM services will become more and more complex as concepts such as protocol-owned liquidity and centralized liquidity evolve, and the adoption of 2-tier solutions will help make AMM transactions cheaper, faster, and more convenient.