Original Title: Uniswap V3's Concentrated Liquidity vs. Trader Joe's Liquidity Book

Author: Kofi J, CoinGecko

Compiled by: BlockTurbo

Comparison of Uniswap V3 and Trader Joe AMM Models

Uniswap V3's concentrated liquidity and Trader Joe's liquidity book model are protocol-level upgrades designed to improve liquidity efficiency in the DeFi space. Uniswap allows liquidity providers (LPs) to choose custom price ranges, while Trader Joe uses discrete "price bins" to allow LPs to define fixed price ranges for precise liquidity deployment.

The crypto market trades around the clock without rest. The financial value of digital assets directly stems from user demand, making their valuation more efficient compared to traditional assets like stocks, which are primarily valued based on profits.

However, for various reasons, capital efficiency in the DeFi space remains low. The core reason for this inefficiency is the fragmentation of the DeFi ecosystem. This fragmentation exists not only within individual chains but also includes a two-tier system of centralized and decentralized services. The state of DeFi is also constantly changing. Emerging protocols naturally start inefficiently and become more efficient over time; however, these inefficiencies often spill over into other areas within the "financial Lego" system of DeFi.

As DeFi evolves and matures, these inefficiencies will be naturally addressed through protocol-level development and an increasing number of arbitrageurs, who play a crucial role in the health and functionality of the ecosystem by filling gaps and profiting in the process.

The concentrated liquidity model of Uniswap V3 and the liquidity book model of Trader Joe provide excellent examples of liquidity efficiency upgrades at the protocol level. In this article, liquidity efficiency will refer to the optimization of the utilization of currently available capital as much as possible.

What is Liquidity and How to Understand the AMM (Automated Market Maker) Model

The term liquidity can be understood as how easy it is to exchange one asset; how quickly an asset can be bought or sold without affecting market prices. Overall liquidity in cryptocurrencies has been strengthened and has seen tremendous growth. Comparing the total market cap of Ethereum before the 2017 bull market with today's market cap:

• In 2017, Ethereum's market cap was $27,681,279,352, with a daily trading volume of $456,818,455;
• In 2023, Ethereum's market cap is $251,586,840,870, with a daily trading volume of $9,272,832,786.

Ethereum's market cap has grown by over 800%, and its daily trading volume has increased by over 1000%. These trading volumes are still distributed across various centralized and decentralized exchanges. But overall, compared to the 2017 market, the current market is much better at absorbing a $10 million Ethereum sell order due to increased liquidity depth.

Every trade requires a counterparty: buyers need sellers, and sellers need buyers. Centralized exchanges use an order book model to match buyers and sellers. Centralized exchanges also rely on market makers (MMs) to provide deep liquidity on both sides, profiting by charging the so-called bid-ask spread.

A typical example of a market maker in the cryptocurrency space is Wintermute, which recently earned 40 million ARB tokens from market-making activities. Market makers remain crucial because low liquidity can lead to slippage; if the execution price differs from the expected price, traders will use another more efficient service.

How the Automated Market Maker (AMM) Model Works

The success of Uniswap comes from implementing the Automated Market Maker (AMM) model, which has become the blueprint for every subsequent decentralized exchange.

Instead of connecting two traders, the trader buying an asset uses a liquidity pool as a counterparty without the need for intermediaries. The AMM model relies on incentivizing liquidity providers through trading fees, while smart contracts rebalance the liquidity pool using a basic formula to keep the asset ratios constant: x*y=k.

Users provide liquidity in the form of LP tokens, participating in market-making activities, making permissionless trading of digital assets possible.

Uniswap V3 Concentrated Liquidity

Uniswap V3 was launched in May 2021, introducing the concept of concentrated liquidity. This model focuses on maximizing capital efficiency to achieve better trade execution and increase fee income for liquidity providers.

The core innovation lies in allowing liquidity providers to choose custom price ranges: each liquidity provider has a custom price curve, and traders execute trades based on the sum of these price ranges.

As shown in the image above, this is the liquidity pool for ETH-USDT. Choosing the full price range reflects the standard liquidity distribution in V2 pools. The capital of liquidity providers is evenly distributed along the price curve, which has the advantage of being able to handle all price ranges from zero to infinity. However, considering that the vast majority of trades occur within a narrow price range, much of this capital remains unused, resulting in very low efficiency.

In the example above, a custom price range for ETH-USDT has been selected. Liquidity providers will earn proportional trading fees based on their liquidity contributions within the predefined range ($1,706 to $2,303). In recent weeks, most Ethereum trades have occurred within this range, allowing liquidity providers to earn similar amounts of trading fees with far less capital than in V2 pools, or to deploy the same amount of capital and earn more trading fees. In both cases, liquidity providers benefit more, thanks to improved liquidity efficiency.

The concentrated liquidity pools of Uniswap V3 are particularly advantageous for stablecoin pairs trading within narrow ranges, where up to 99.95% of liquidity capital in these pairs was never utilized in V2.

Game theory plays a role in V3 pools, as users can choose where to allocate their capital. Thus, some providers will target less likely but more profitable ranges, considering that liquidity provision in those ranges is relatively high, while others will focus on narrower ranges. This ensures that the price curve follows a reasonable distribution.

Overall, V3 pools allow for greater liquidity depth, meaning lower slippage for traders and that liquidity providers can earn the same trading fees with less capital. The second-order effects mean that the capital saved can be put to productive use in other areas of DeFi. Concentrated liquidity is a great example of how protocol-level liquidity efficiency upgrades can benefit all users.

Trader Joe's Liquidity Book

Many people know that Trader Joe is a superstar DEX on Avalanche. However, Joe V2 quickly became one of the most popular decentralized exchanges on Arbitrum, gaining attention after the ARB airdrop and massive trading activity. Trader Joe's new liquidity book model has driven this growth.

What are Bins in Trader Joe's Liquidity Book Model?

Understanding Bins is crucial to grasping the liquidity book model. In Trader Joe V2 pools, liquidity is deposited into different price bins. Each bin has a fixed price, and liquidity is placed into these different bins.

As long as trades remain within the range of a bin, users trading within a bin can obtain a fixed price, meaning there is no slippage and price efficiency is extremely high. All bins combined provide deep liquidity, and liquidity providers can choose to create different distributions of liquidity price bins to formulate more advanced strategies.

Liquidity Book Model

The liquidity book model is a new instance of the Automated Market Maker (AMM) model that significantly enhances liquidity efficiency and offers users more flexibility when providing liquidity. For example, they can implement dollar-cost averaging when entering and exiting positions without paying multiple swap fees while earning trading fees.

Similar to Uniswap V3 pools, the liquidity book model allows for concentrated liquidity, enabling liquidity providers to customize price ranges. Liquidity is no longer evenly distributed along the price curve but is precisely deployed to achieve greater trading fee income. Compared to typical liquidity pools, it also has the added advantage of handling larger trading volumes with less liquidity. In short, the liquidity book can serve a large number of traders with minimal liquidity. This model breaks away from the increasingly outdated paradigm of relying on attracting large amounts of captive liquidity to provide effective pricing.

Thanks to the liquidity book model and its use of "price bins," traders can enjoy zero slippage trading. Each bin is a single price point, and Trader Joe aggregates all these bins into a liquidity pool. "Active Bins" contain both tokens in the pair and determine the current market value of the assets. "Active Bins" are the only bins that earn trading fees, and trades conducted within these bins experience no slippage. The introduction of bins even upgrades the concentrated liquidity of Uniswap V3, as the precision and concentration of liquidity at more narrowly defined price points are higher.

When all liquidity in a bin is exhausted, the price moves to the next bin. This dynamic structure is a key feature of the liquidity book model. This model flexibly adjusts liquidity distribution, making trades more efficient. Different bins provide liquidity within specific price ranges, allowing for quick adaptation to market demand when needed. This dynamic structure helps reduce slippage and provides traders with better execution prices.

The above image shows the options for liquidity providers when using Trader Joe V2 pools: Spot, Curve, Bid-Ask, and Wide.

Here’s a simple example of how to utilize the Spot shape distribution:

In this ETH-USDC pool, liquidity providers can choose a range above the current market price and only provide ETH to the pool. As the ETH price rises and gradually crosses various bins, users will progressively sell ETH and receive USDC. In the example above, the chosen price range is relatively small, but users can select any price target they desire, making it a simple method for gradually selling an asset.

Conversely, users can utilize the liquidity book model to supply ETH below the current market price in a one-sided manner to purchase in batches. By using these two applications of the Spot shape, users can gradually buy or sell in a single transaction while earning swap fees in the process.

The Spot shape offers liquidity providers incredible freedom and flexibility in deploying liquidity. The fewer the number of bins, the more concentrated the liquidity; thus, their share of income from all trades within this range is larger. At the same time, if the price exceeds this range, liquidity providers face the greatest risk of impermanent loss.

Liquidity providers can observe where other market participants are depositing liquidity on Trader Joe; the above image shows the current liquidity distribution for ETH-USDC.

The above image outlines several strategies from Trader Joe, allowing users looking to provide liquidity to choose the shape that best fits their goals. It is strongly recommended that users start with test funds to gradually understand how the liquidity book model works before committing all their capital.

In summary, the liquidity book model provides a new level of flexibility for liquidity supply, reduces slippage, and allows for more dynamic liquidity rebalancing, essentially opening up a new paradigm for traders and liquidity providers within DeFi.

Disadvantages

Impermanent Loss

Impermanent loss is the greatest danger faced by any liquidity provider. Simply put, impermanent loss is the difference in value between deposited assets and withdrawn assets. When asset prices fluctuate significantly, liquidity providers face losses, but hope that trading fees can compensate for this. In many cases, it may be more profitable for investors to hold tokens in a wallet rather than provide liquidity.

In both models, liquidity providers face a greater risk of impermanent loss compared to traditional liquidity pools, as liquidity is distributed within a narrower range. Impermanent loss occurs when asset prices exceed the specified range; the smaller the range, the greater the chance of impermanent loss. But as a trade-off for this higher risk, liquidity providers have the opportunity to earn more trading fees, which is a typical scenario where risk and reward rise in parallel.

One might think that since Trader Joe's liquidity book model allows for more specific liquidity supply, liquidity providers will face the greatest potential impermanent loss in these funds pools. However, Trader Joe has introduced a volatility accumulator that monitors bin changes to gauge volatility. When volatility rises, the volatility accumulator automatically increases swap fees, helping to protect liquidity providers from the impact of impermanent loss.

Complexity

Both Uniswap's V3 pools and Trader Joe's liquidity book model implement more concentrated liquidity supply, bringing higher trading fees for liquidity providers and better trade execution and lower slippage for traders. However, both are more complex than the liquidity supply many crypto users are accustomed to. This added complexity can lead to more severe mistakes by users, making it essential to experiment and trial-and-error with each model.

Specifically regarding the liquidity book model, liquidity providers are only limited by their imagination. However, during market volatility, they can easily be pushed out of their bins, leading to impermanent loss, and they require a more active management style. Nevertheless, the nuances and complexities involved constitute part of the rewards of this new era of liquidity supply.

Competition Will Drive Growth and Benefit DeFi

On the surface, Uniswap's V3 pools appear to be more user-friendly than Trader Joe's liquidity book model. However, in terms of liquidity efficiency, the liquidity book model surpasses the V3 pools. If operated correctly, the immense flexibility provided by price bins makes liquidity supply more attractive and profitable.

The new levels of capital efficiency introduced and nurtured by both pools positively impact DeFi, freeing up capital for other productive uses. As both DEXs are incentivized to provide the best trading experience to attract users to their platforms, the continued development of liquidity efficiency at the protocol layer of DeFi is imperative.