Uniswap is known to be the largest decentralized exchange for cryptocurrencies. The introduction of Uniswap V1 as a proof of concept for automated market makers (AMMs) has triggered exponential growth in AMM adoption since 2018.
However, Uniswap V2 AMMs in early 2020 made a case for passive liquidity provision strategies, they still lag behind active liquidity provision strategies in achieving capital efficiency.
The launch of Uniswap V3 in mid-2021 brought up a concept of concentrated liquidity. Uniswap V3 allows liquidity providers to allocate their capital in specific price ranges for each trading pair. While the price of the pair remains at that range, the liquidity provider earns rewards proportionally to the amount of liquidity allocated and volume traded in that price interval.
Also, considering the varying degrees of risk implied by underlying tokens, Uniswap V3 offers multiple fee tiers for liquidity providers. All these new features make adequate liquidity positions in Uniswap V3 more profitable than in Uniswap V2. This induces the problem of strategic liquidity provision: smaller intervals result in a higher concentration of liquidity and larger rewards when the price remains in the interval, but at the same time put on a higher risk.
New features of Uniswap V3 open the way for low-slippage trade execution and come quite close to the central limit order books on centralized exchanges, where smart and fast adjusting of the liquidity ranges are essential.
Although Uniswap V3 delivers a higher degree of capital efficiency through the elimination of unused collateral and offers higher fees for liquidity providers, it also increases the risk of impermanent loss.
The problem of impermanent loss
Impermanent loss is a common term in DeFi when speaking about liquidity providing.
The latter occurs when the price allocated to the liquidity pool changes compared to the price at the time of the initial deposit. Since liquidity providers pair two assets together to form a position, the impermanent loss typically happens when the ratio of the tokens in the liquidity pool becomes uneven. Impermanent loss is not realised until the tokens are withdrawn from the liquidity pool, hence the name “impermanent”. Therefore, liquidity providers can potentially recover from the loss if they are able to pull their tokens out at the same price they were deposited.
In reality, this particular condition remains difficult to meet and the impermanent loss becomes permanent. Unfortunately, Uniswap V3 concentrated liquidity implies that the impermanent loss will also follow the same property and incur more loss for such positions unless properly managed. According to research by Topaze Blue and Bancor, half of Uniswap V3 liquidity providers are losing money. For almost all pools impermanent loss surpasses the fees earned during the period and the average liquidity provider in the Uniswap v3 has been financially harmed by his choice of activities and would have been more profitable simply holding the assets.
Market making as a solution to the impermanent loss in active liquidity provision strategies
Fast adjusting of the liquidity ranges is becoming a new and important service delivered by market makers on Uniswap V3 and other new versions of DEXs. The market maker will therefore optimise earned fees by selecting proper price ranges while minimising the impermanent loss.
However, gas fees remain as a direct parameter concerning optimal market-making on Uniswap V3. Such fees can account for hundreds of dollars worth of ETH per action on the protocol, paid to the network. Thus, in parallel, the market maker adapts its strategy regarding the network congestion, otherwise, a very dynamic liquidity provision scheme would be drained out by substantial fees.
In that matter, Layer 2 solutions like Optimism or Arbitrum will, in the future, play a decisive role in low-latency DeFi market-marking. Nevertheless, other chains, such as BSC, currently offer lower network fees, therefore, allowing advanced market-making strategies to be designed, even on Uniswap V2-like protocols such as Pancakeswap.
In a nutshell, moving from Uniswap V2 to Uniswap V3 can be much more efficient and lucrative for token issuers. However, this is only the case if the liquidity pool is properly managed, which can be achieved with sophisticated market-making strategies.