Interpretation of Uniswap Fee Switch Pilot: UNI Token Holders Still Find It Difficult to Directly Receive Profit Distribution

Author: Jiang Haibo, PANews

Uniswap's fee switch may really be coming. On December 2, PoolTogether co-founder Leighton published a proposal discussion article titled "Fee Switch Pilot Update and Vote" on the Uniswap governance forum, co-authored with Guillaume Lambert, founder of Panoptic and yewbow, and assistant professor at Cornell University.

Prior to this, the Uniswap community had already discussed the "Fee Switch" design space and subsequent steps, as well as the "Fee Switch" pilot consensus check. The delay until now is due to the need for multiple rounds of discussion in Uniswap's voting process, during which many expressed a desire for more time to study the proposal before voting.

Uniswap's Governance Process and Rules

To make a proposal effective through Uniswap's governance process, it must go through several steps, which are longer and more complex than those of other protocols.

1. Submit the proposal in the "Proposal Discussion" section of the governance forum.
2. Contact Uniswap's Discord administrators to discuss the proposal in community calls and Twitter Spaces.
3. Create another post in the forum's "Temperature Check" section and publish a Snapshot temperature check vote, which lasts for 2-5 days. This requires delegating or self-delegating 1,000 UNI tokens. For the Snapshot vote to be valid, at least 25,000 UNI must participate.
4. Update the temperature check post based on community feedback.
5. Conduct a consensus check vote on Snapshot. This operation requires delegating at least 1,000 UNI tokens. If 50,000 UNI participate, it is valid.
6. Upgrade the proposal to an on-chain vote, requiring at least 2.5 million UNI tokens to be delegated. Retail investors can gather and collect enough votes to publish the proposal on-chain through websites like Fish.vote.

The Proposal Will Test the Impact of the "Fee Switch" on Protocol Usage

Since the V2 version, Uniswap has had a built-in "fee switch," which allows Uniswap to collect a portion of transaction fees as protocol fees if activated. So far, all transaction fees have been allocated to liquidity providers, helping Uniswap maintain the highest market share among DEXs.

After discussions in the Uniswap governance forum and the community, the fee switch pilot proposal passed the temperature check and consensus check votes on Snapshot in July and August, respectively. Now everything is ready, just waiting for the final on-chain vote.

According to the proposal, it is solely for testing the impact of the "fee switch" on protocol usage and is just a pilot project. Activating the fee switch will not increase the costs for those using the protocol for trading but will retain a small portion of the fees currently paid to liquidity providers.

To limit the pilot's impact on liquidity providers, this pilot is restricted to ETH-stablecoin trading pairs, lasting 120 days, with 10% of transaction fees collected as protocol fees. The selected trading pairs include: ETH-USDT-0.05%, DAI-ETH-0.3%, and USDC-ETH-1%, covering the three most common stablecoins in the Ethereum ecosystem and all three common transaction fee tiers.

Although the Alastor team previously suggested not to activate the fee switch for liquidity pools with "lower fee tiers" (Alastor had received funding from the Uniswap Foundation to provide strategic analysis and advice on the implementation of the fee switch), doing so might reduce Uniswap's trading volume and market share, as the fee proportion received by liquidity providers is already low.

However, for ETH-stablecoin trading pairs, the current professional liquidity providers and major trading volumes are concentrated on the 0.05% fee trading pairs. If fees are only charged on higher fee tiers, retail investors will be more significantly affected.

Impact on the Uniswap Foundation, Liquidity Providers, and UNI Token Holders

Impact on the Uniswap Foundation

The Uniswap Foundation is more concerned about potential regulatory and legal issues, especially after Circle cooperated with U.S. Treasury sanctions and the CFTC further sued the DAO, which means UNI holders may ultimately bear responsibility.

The Uniswap Foundation has also expressed concerns about questions like "Will UNI tokens become securities?", "Do the trading pairs that charge fees include securities?", and "Will this bring income tax implications for the DAO and UNI holders?"

To address this, Uniswap is currently taking a more conservative approach. For the selected trading pairs, only tokens like ETH and stablecoins, which "have not undergone public regulatory review regarding whether they are securities," are included.

Impact on Liquidity Providers

Liquidity providers selected for the pilot on the three trading pairs are likely to experience the most direct loss of benefits, as their income will decrease by 10% under unchanged conditions.

In the Uniswap forum, some liquidity providers have expressed concerns about a potential decrease in their income, and due to the liquidity concentration in Uniswap V3, the risk of impermanent loss for liquidity providers is not small.

However, according to the views of the two authors of the proposal, the primary focus is on the impact of the fee switch on the execution of trades by traders, without considering whether liquidity providers will be negatively affected.

If liquidity providers' income decreases, it may lead to a migration of liquidity to other fee tiers or even an exit. If liquidity providers exit, Uniswap's liquidity will decrease, increasing slippage and fees for trades, which may cause traders to turn to other DEXs, resulting in a decline in Uniswap's market share. If this happens, the fee switch experiment may be paused after 120 days.

Impact on UNI Token Holders

This experiment also does not consider the allocation of the 10% protocol fee; the 10% protocol fee will remain "uncollected" in the smart contracts of each mining pool until an agreement is reached through governance voting on the use of the funds.

Therefore, charging liquidity providers does not mean that UNI token holders will receive the protocol fees, and the subsequent use will also be decided by voting.

Conclusion

Uniswap is about to decide through on-chain voting whether to activate the "fee switch" experiment, charging 10% of transaction fees for the selected three ETH-stablecoin trading pairs. This experiment is solely for testing the impact of the "fee switch" on protocol usage, specifically whether it will reduce Uniswap's market share, while the potential decrease in liquidity providers' income is not within the scope of consideration, nor does it mean that UNI holders can receive income from protocol fees. Whether it can be expanded to all trading pairs later also needs to consider whether the trading tokens are securities.

Under the liquidity concentration conditions of Uniswap V3, liquidity providers bear a significant risk of impermanent loss. If liquidity providers shift to other similar trading pairs, such as from ETH-USDT-0.05% to ETH-USDC-0.05% or ETH-USDT-0.3%, the impact on Uniswap would not be substantial. However, if liquidity providers reduce liquidity due to decreased income, increased slippage and fees for trades may also lead to a reduction in Uniswap's market share.