Why Uniswap V3 is set to transform DeFi, and then crypto

Uniswap V3 launches May 5th, 2021

In a space that has only gained significant traction over the past 12 months, it feels almost anachronistic to be declaring a completely game-changing addition to decentralized finance (DeFi). Declaring it we are, though.

Launching today, May 5th, 2021, Uniswap V3 is set to transform the fundamental infrastructure that underpins automated market makers (AMMs). From liquidity provision to layer 2 scaling and an entirely new base-case for non-fungible tokens (NFTs), there is little that V3 doesn’t switch up.

From pioneer to pioneer

Launched in November 2018, Uniswap V1 was a pioneering decentralized exchange (DEX) that has since set the standard for AMMs. Uniswap and popular forks (aka clones) such as SushiSwap and Pancakeswap have now come to rival their centralized, non-automated competitors both in terms of user numbers and average daily trading volume.

The launch of V2 in May 2020 cemented Uniswap as the leading DEX and catalyzed the enormous growth of DeFi over the summer. V2 introduced the now-popularized user-led liquidity model that allows platform users to deposit ERC-20 tokens into liquidity pools in return for trading fees and LP tokens with further utility. In turn, these pools provide the liquidity for trading, making the whole platform go round without market makers or order books.

Customized, hyper-efficient liquidity

Such is the level of Uniswap’s game that it now accounts for around 20% of the DEX market and recently surpassed $2 billion in daily trading volume. Not content to rest on its laurels though, Uniswap has created even more radical changes to V3 than previous iterations, pushing AMMs in an entirely new direction while solving many of their most salient issues.

The first of these is what V3 is calling “concentrated liquidity”. Concentrated liquidity allows liquidity providers (LPs) to choose exactly what price range they want to provide liquidity in, rather than the system spreading assets inside a pool across all possible price ranges. This, in turn, creates a type of order book akin to a centralized exchange (CEX) while also limiting the much-feared risk of impermanent loss.

This seemingly small change means that an LP in V3 depositing $1,200 into a pool could earn the same level of fees as one that deposits $10,000 in V2 — making their capital work 8.34x harder. This is because assets typically trade within a range at any given time, rather than swinging from $0 to infinity, which V2 pools currently distribute liquidity to cover. This capital efficiency makes liquidity provision much more attractive for users as well as professional market makers.

The below image taken from Finetmatics’ video on Uniswap V3 shows how this might work in an ETH-DAI liquidity pool in V2 vs. V3.

Fewer losses, more opportunities

Uniswap developers believe this small change is going to increase capital efficiency by an incredible 4000x compared to V2, allowing LPs to earn higher returns while helping them to limit losses in a significant market event that wipes out their liquidity (i.e. losing $1,200 rather than $10,000 in the above example should ETH go to $0).

Other user-friendly features of V3 will see LPs able to choose to deploy their capital in multiple fee ranges within a pool, allowing them to take advantage of multiple pricing opportunities for much less capital. They will also be able to choose their fee level, from 0.05% for making a market for less volatile assets like stablecoins, to 1% for more “exotic” pairs.

Sophisticated market making

Stepping into CEX territory, V3 users will also be able to set range limit orders by stipulating at what price an asset moves from one to another (DAI to USDC, for example) and then pull their capital before it falls back to below that price and is reconverted. As the below graphic shows, this could lead to a tidy gain for LPs while opening the door for more sophisticated market-making strategies across the platform.

Importantly, all this customization is being made possible using one of DeFi’s chief innovations: NFTs (non-fungible tokens). Rather than LPs’ positions being distributed as fungible ERC-20 tokens, they will be represented by non-fungible ERC-721 tokens. These will also contribute to widening the potential of advanced market-making strategies across V3, as well as secondary trading opportunities.

Taking DeFi to the masses

Last on the list of major innovations from V3 (there are still plenty of minor ones we don’t have space for here) is V3’s plans to launch on the layer 2 protocol Optimism once deployed (with an estimated release in July 2021). While the development team says lower gas fees will be a natural hallmark of the innovations brought by V3, moving onto a practically fee-free layer 2 protocol really will change the DEX pricing game.

While layer 2 protocols like Polygon/Matic, xDai and Loopring have been gaining traction of late, moving one of DeFi’s biggest and best-known exchanges onto a layer 2 could kickstart movement in a very big way. This, in turn, could expand the Ethereum and thereby DeFi ecosystem exponentially, allowing for a new wave of scaling and innovation that could really begin to pose a threat to traditional finance.

Within the crypto sphere, the incredible capital efficiency that V3 will bring should work to significantly reduce slippage on trades, which will pave the way for execution times that could compete with some of the big centralized exchanges. Combined with the ability to set range limit orders, this might prompt some movement between crypto’s two biggest segments.

All these factors and more could see V3 become quite the disruptive force, one that could not only change how things are done in DeFi, but potentially change the shape and direction of the entire cryptocurrency industry.

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