The Two Sides of the Coin: Does Uniswap V3 Bring More Efficient Capital or Amplify LP Losses?
Unless the LPs of V3 actively adjust their price ranges, there is a risk of completely losing exposure to low-priced assets and becoming easy prey for arbitrageurs.This article is from IOSG, original title: "Uniswap v3: Towards Capital Efficiency or Amplifying LP Losses?", authors: Momir Amidzic and Danning Sui.
Uniswap v1 and v2 implemented a simple unified XYK pricing curve. When large transactions occur, liquidity can be guaranteed at low asset utilization and exponentially increasing prices within any price range. Therefore, the only way to reduce price slippage is to increase the K value, which is achieved by attracting more funds into the liquidity pool, i.e., increasing the Total Value Locked (TVL).
Advantages of Range Orders
V3 is much less dependent on TVL because it allows liquidity providers to establish multiple positions within specified price ranges. Thus, the concept of concentrating liquidity near the market price replaces the idea of "infinite" liquidity.
Source: Uniswap v3 Whitepaper
The method of concentrating liquidity has long been established in DeFi. Curve and DODO have practiced this from different angles for some time. However, Curve focuses solely on stablecoins, while DODO uses price oracles to concentrate liquidity near market prices.
Both Curve and DODO's designs revolve around providing passive liquidity; nevertheless, V3 achieves capital efficiency by relying on the concept of rational liquidity providers who "can keep their liquidity active by concentrating it in a narrow area around the current price and adding or removing tokens as prices change, thereby reducing their capital costs."
Conceptually, this makes sense; but what about in practice?
To assess V3's performance, we first need to check whether it indeed reflects an improvement in capital efficiency. One way to measure this improvement is to observe the capital turnover rate of V3 compared to V2. Therefore, we observe the daily TVL turnover rate and compare it with V2 and Sushiswap.
As shown in the figure above, V3's TVL turnover rate is much faster than that of V2 or Sushiswap. For instance, during the market crash on May 19, the $1 TVL provided to V3 could translate into over $1.7 in daily trading volume. V3 shows significant improvement compared to V2. In the same situation, V2 only generates about $0.2 in daily trading volume.
High capital efficiency is indeed a characteristic of V3!
Another aspect is whether V3 offers better prices than V2. Typically, when using V3, we receive the following information:
One way to compare is to check the trading volume allocated to V2 versus V3 by DEX aggregators. To this end, we examined the two largest DEX aggregators, Matcha and 1inch. Both aggregators provide optimal prices for end users, so they direct most of the trading volume to the most competitive venues.
In general, as shown in the figure below, we observe a trend where aggregators allocate most of the volume to the latest version of Uniswap, indicating better pricing.
Source: https://duneanalytics.com/queries/49999/98616
Source: https://duneanalytics.com/queries/50020/98653
Aggregators introduce on-chain liquidity in two ways—either through bridging contracts or through "VIP" routing directly into Uniswap pools. The latter is optimized and incurs lower gas fees than Uniswap's own routing. Therefore, considering gas fees adjusts to a better price. Currently, neither Matcha nor 1inch has enabled VIP routing. This indicates that the liquidity of Uniswap V3 could be more competitive than what is currently displayed.
The Other Side of the Coin
After discussing the advantages of the recent upgrade, we also need to explore the potential downsides of the new design.
Here, it is worth reminding readers that one of the issues with V2 is the impermanent loss faced by liquidity providers. Assuming price discovery mainly occurs on centralized exchanges, any price discrepancies present arbitrage opportunities: buying undervalued tokens from the pool or selling overvalued tokens to the pool.
V3 does not solve the issue of impermanent loss, but the magnitude of the loss can be determined by the behavior of LPs. In other words, in V2, LPs are relatively static compared to arbitrage, while in V3, both LPs and arbitrageurs have pricing power. This creates an interesting dynamic between the two, with roughly two possible scenarios.
In the first scenario, LPs can restrict arbitrageurs. This requires mature LPs to continuously adjust their price ranges, accurately reflecting market price changes before arbitrageurs act, thereby protecting LPs from arbitrage impacts in highly volatile markets.
The second scenario targets less mature LPs, favoring arbitrageurs. That is, a narrow price range means greater liquidity depth, which also means a higher risk of incurring losses in a turbulent market environment.
Assuming we provide liquidity for ETH, as shown in the figure below. Our capital only becomes active once the ETH price exceeds $2817.5. If the ETH price eventually rises above $3138.8, the LP's position will be entirely composed of DAI, and the LP will have zero risk exposure to further increases in ETH. After that, the liquidity of DAI will remain inactive until the ETH price falls back within the range. If ETH falls back into the range at some point and continues to drop below $2817.5, the LP's position will be entirely composed of ETH.
Thus, in the case of an ETH bull market, LPs lose exposure to price increases, while in a bear market, LPs face 100% exposure to downside risk. Assuming a price lag between centralized exchanges and Uniswap, arbitrageurs will suppress LPs.
Greater LP Losses?
Although it is still too early to make a judgment, we can empirically look at how much trading volume in V3 comes from the top-ranked arbitrage bots. We assume that more bot activity means greater LP losses.
As shown in the table below, since its inception, the largest bot has accounted for 15.5% of the total trading volume on Uniswap V3! Since the launch of V3, this single address has generated $3 billion in trading volume. Additionally, the top 5 arbitrage bots account for about 22% of the total trading volume, significantly higher than the level in V2, where the top 5 arbitrageurs accounted for about 11.2% of the total trading volume during the same period.
Source: https://duneanalytics.com/queries/51415/101669
Source: https://duneanalytics.com/queries/51461/101708
This also indicates that LPs suffered significant losses in the early days of V3. But why is there such a large difference compared to V2?
While the unified XYK pricing curve implemented in V2 is not the most capital-efficient solution, it still provides LPs with some degree of protection, as slippage increases exponentially. Therefore, even if V2 token pricing is incorrect, it is impossible to withdraw undervalued tokens from the liquidity pool. On the other hand, unless V3 LPs actively adjust their price ranges, they risk completely losing exposure to low-priced assets or having their positions entirely composed of high-priced assets, making them easy targets for arbitrageurs.
Top 5 active bots' trading volume share; Source: https://duneanalytics.com/queries/51508/101777
What Does the Future Hold?
We expect that arbitrage participation in V3 will gradually decrease over time for the following reasons:
LPs can better manage risks with lessons learned from previous experiences.
Further specialization in liquidity provision, with more LPs utilizing dedicated vaults for active management.
Layer 2 deployments and low gas fee environments support more aggressive LP strategies.
Potential MEV-proof strategies that can benefit traders, reduce slippage, and lower gas costs.
Uniswap V3 has made a good start. Although there are areas that need continuous improvement, we remain optimistic about the future development of V3. Ultimately, we will see more specialized market makers becoming liquidity providers, squeezing out arbitrageurs with better pricing. Passive liquidity will become a thing of the past, provided only through dedicated vaults. Overcoming the current drawbacks requires an ecosystem layer for liquidity yield management, including dApps like Alchemist, Charm, and Visor, which will support DeFi products to reach a higher level.
