A powerful incentive of AMM-based DEX for liquidity provision
The results from analyzing the operation of Uniswap V2 and V3 reveal answers to the research question. In most circumstances, exchange operators have a motivation to attempt to and enhance the observed volume on a certain exchange. Increased volume indicates increased liquidity and trust, which will attract more people. This motivation may differ for completely decentralized exchanges, but it is a significant aspect to consider for most existing ones. According to the previous section, V3 market is extremely active when gradually occupying the market share of its predecessor, especially recently when the number of users participating as traders in both versions has become equal. Although the number of pairs made on V3 cannot be compared with a huge variety of pairs on V2, it does not affect the number of swaps executed on V3, particularly in May 2022. All these aspects are facilitating V3 to be an attractive market for liquidity providers and become a successor to replenish the shortcomings of the previous version in which many of the LPs are no longer active.
The number of liquidity providers withdrawing from V2 may have entered the potential market V3, consequently, the liquidity in V3 is gradually being on par and even higher than V2 in recent times, contributing more than half of the liquidity for Uniswap in general. Market activists encourage growth in trading volume, LPs become more proactive, and more importantly, V3's fee-tier feature delivers a relatively high portion of the return for LPs. The pool fee obtained on V3 is approximately 6 times higher than on V2. The more transaction fees are collected, the more fee return LPs get (fee return = total fees earned / total value locked). In the new model of AMM, LPs actively set the capital levels, price range and fee tier and aren't required to have too much capital. Although V3 has only been running on Polygon for the past half year, the transaction volume so far accounts for 67% of the value on V2 and transaction fees are equal to 20% of that of V2. Although Ethereum remains the most reputable platform for Defi applications, running an exchange on layer 2 solutions is feasible. As the volume of transactions is gradually increasing close to its predecessor, it demonstrates that Uniswap V3 Polygon has solved the problem of transaction fees for traders.
On a whole, improving the AMM mechanism to CLMM creates an extremely attractive incentive for LPs when they have a high volume trading market, higher returns on fees than before, optional setting fees and less capital investment and less transaction fees. Looking more broadly, DEX's paradigm refinement is taking the right steps and investors are adapting to the dynamics provided by this AMM-based exchange.
Fig. 75. An overview of Uniswap V2 activity in the last 90 days (Source: BitDegree.org)
Fig. 76. An overview of Uniswap V3 activity in the last 90 days (Source: BitDegree.org)
Liquidity providers behaviors towards the incentive
LPs are interested in what the new AMM model offers. Initially, LPs prefer to provide liquidity at a 0.3% fee over other fee tiers; they are probably familiar with the fee rate of the previous version. Surprisingly, the fee that is preferred by the majority of LPs is not very profitable, a lower fee 0.05% brings the most profit to them. Therefore, there is no similarity between the traders and the LPs when LPs always want higher fees to get more profits, and traders are willing to swap more with low fees. Although fee is suggested based on the volatility and risk level of the token pairs, the decision on fees is in the hands of LPs. USDC/WETH is the most popular trading pair and generates the highest fee for LP with 0.05% and 0.3%. Besides, the pair of ETH and stablecoins are traded the most, USDC/WETH is preferred in Uniswap V3, both USDC/WETH and USDT/WETH are at the same position in Uniswap V2.
The dominance of Uniswap V3 as well as the CLMM model does not stop here; another exceptional quality is its amazing flexibility. Uniswap V3 presents a new concept of active liquidity, in contrast to V2, which simply allows users to passively contribute liquidity. By utilizing liquidity and price ranges to make limit orders and complete trades, Uniswap V3 enables users to use Uniswap as an active tool to carry out liquidity provision in a more productive and profitable way. However, it becomes difficult and takes time to provide liquidity, and the risks for the end-users have escalated. To determine the effect this new version has on the protocol's usability, it is also worthwhile to look at the present state of liquidity on Uniswap v3. Approximately 70 percent of positions are out of range. The pairs of volatile and stablecoin are more likely to be out of range than the pair of volatile and volatile tokens due to its higher correlation between assets. Capital efficiency has its own side effect. The LPs are likely to run the danger of market prices straying outside of the defined market-making range. 70 percent is a red alert for those who cannot actively manage their fund in CLMM.
The so-called “Limit-order” strategy, which enables consumers to set up positions with out-of-range liquidity, is not applicable to some of the positions. This information must be thoroughly investigated since it makes it very evident that Uniswap lacks the ability to restructure or rearrange positions for a variety of potential uses.
Compare and contrast to previous studies
In June 2021, a research of Nansen.ai was interested in the active liquidity management of Uniswap V3 as well as the decentralized exchanges.
Fig. 77. Active and passive liquidity provider in Uniswap V3 in June 2021(Source: Nansen.ai)
An address was considered "simple passive" if it just has one Uniswap V3 position and hasn't changed it subsequently. Almost all of these owners (77%) were still regarded as passive liquidity liquidity providers. This implies that after minting liquidity, they had hardly ever changed their liquidity situations. There were only 8 complex passive LPs. Although the data was studied last year, since Uniswap V3 was deployed on the mainnet. This also shows that the issue of flexible liquidity occurred from the very beginning, which is not only the responsibility of Uniswap V3 but also of the LPs to understand the main purpose of providing active liquidity, a new concept that Uniswap introduced.
Except for the issue of liquidity positions, Uniswap V3 has a good performance in my research results. Another study by Liao G & Robinson D provides a whole picture of Uniswap V3 compared with other centralized exchanges.
Fig. 78. Market depth comparison for Binance, Uniswap V3 and Coinbase (Source. Uniswap.org)
Generally, in spot trading over the previous few months, Uniswap v3 has had much more market depth than the two biggest centralized exchanges Binance and Coinbase in terms of the large-cap token pair such as ETH/USDC (Uniswap V3), ETH/USDT (Binance), ETH/USD (Coinbase). In addition, Uniswap v3 has greater average market depth on stable pairs and mid-cap pairs. The liquidity benefit in Uniswap V3 increases with the anticipated price impact.
Due to the different risk-and-return profiles of market makers in DEXes and CEXes, Uniswap makes a larger pool of more passive capital, especially Uniswap V2. Uniswap v3 provided a concept of concentrated liquidity that needed rebalancing (Liao G & Robinson D, 2022). The vast majority of capital invested for liquidity provision on Uniswap V3 is relatively passive, even with rebalancing demands.
This research aims to look for the current state of adoption in AMM-based Decentralized Exchanges by answering two main questions about the performance of the AMM upgraded model and the behavior of the liquidity providers towards the performance in the case study of Uniswap V2 and V3. Aftering presenting the key findings, compare and contrast to the previous studies, we can generalize the state of DEXes currently. The adoption of DEX has improved for users as a result of AMM's core model upgrade to address market liquidity and price efficiency. Using capital is far more efficient, liquidity is more stable, layer-2 solution reduces the cost of transactions on the blockchain. Users' reactions to DEX adoption are highly positive, which is consistent with analysts' predictions that DEXs will soon be widely used.
Most of the research's questions have been answered by the findings. But after looking at the data, I found another aspect of this new AMM design. Theoretically, very little study has been done to determine whether the new CLMM model suffers from permanent loss or whether Uniswap V3 can resolve the permanent loss issue with V2. In the Uniswap V3 whitepaper, there is no evidence about this issue, there is only one research paper digging deeper into the impermanent loss of Uniswap V3. Stefan L et al (2021) found that LPs suffered a loss of $260.1M on Uniswap V3 as of Nov 2021. Thus, besides the factors that positively affect the adoption in DEXes, there are also factors that need considering such as how the impermanent loss occurs in the CLMM model. The so-called “passive income” needs reviewing in Uniswap V3 in case the LPs must be more proactive. The DEX hasn't set up a suitable fee mechanism to balance the goals of both the LPs and traders yet.
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