Experts share that Uniswap is the leader of the decentralized exchange that currently locks in the total value. The centralized liquidity feature in Uniswap v3. It releases an overview of protocol upgrading, which is commonly called v3. The Uniswap team launched the Layer 1 Ethereum primary network on May 5 last year, and plans to deploy Optimism as the Layer 2 scalability solution soon after the primary network was launched. So, why does Uniswap v3 improve capital efficiency but fail to provide transient loss protection? This is the content to be discussed in this article today.

Centralized liquidity in Uniswap v3 improves capital efficiency

Uniswap v3 introduces new features designed to optimize its current automated market maker design. It includes centralized liquidity, multiple cost levels and advanced oracle. According to Hayden Adams, the inventor of Uniswap, the team solved three types of risks in the design of Uniswap v3:

1. Price impact

2. Inventory risk

3. Impermanent loss

Price impact refers to the extent to which a transaction changes the market price, which depends on the depth of the market. A higher price impact means that liquidity providers with insufficient liquidity provide traders with lower interest rates. For liquidity providers, inventory risk is essentially price risk, because they hold less wealth in the preferred value storage mode. For example, if users prefer Ethereum, they will hold more bitcoins than Ethereum. Then relatively speaking, it represents a greater inventory risk.

In order to improve capital efficiency and reduce inventory risk of liquidity providers, the team introduced centralized liquidity in Uniswap v3. This feature allows liquidity providers to focus their capital on their preferred assets at a customized price range, so they can provide more liquidity at the desired price.

When the positions of each liquidity provider are summarized into a pool, the combined liquidity of all individual bars forms an order book. The total amount of liquidity in the Uniswap v3 order book looks like a bell curve. Each colored bar represents the liquidity contributed by each liquidity provider. If liquidity providers sell tokens at a price close to the market price, they will get more trading volume and earn more transaction costs.

In Uniswap v3, liquidity providers charge transaction fees based on the liquidity they contribute within the customized price range. When the market price exceeds the specified price range, the liquidity provider will not charge transaction fees. Compared with Uniswap v2, the centralized liquidity of liquidity providers helps minimize the risk of price impact, because liquidity providers usually set the price range close to the market price. Centralized liquidity also reduces inventory risk because liquidity providers can provide liquidity with their preferred assets.

In addition, centralized liquidity improves the capital efficiency of liquidity providers in v3, because they can obtain the same transaction costs as v2, but commit much less capital.

Users still need to suffer from unpredictable losses

One major disadvantage of the centralized liquidity function in Uniswap v3 is that liquidity providers are more vulnerable to volatile losses than in v2. This is because when the market price exceeds its customized price range, limited partners will suffer from unpredictable losses. The tighter the price range, the greater the volatility loss. This creates a trade-off between capital efficiency and volatile losses, as liquidity providers earn transaction fees at the expense of IL.

Although Adams discussed adding the contingency loss protection proposed by Yearn Finance, Uniswap v3 does not seem to meet the expectations of institutional groups in this regard. Jeff Kirdekis, CEO of TrustSwap, believes that Uniswap v3 has improved user liquidity management. However, this is not what the DeFi community expects. A leg user named "CryptoChad" said that Uniswap v3 did not solve some basic pain points of DeFi users, such as high gasoline costs, unpredictable losses and preemptive robots.

Bancor is the only DeFi protocol that provides contingency insurance for its billions of locked liquidity. A member of the Bancor community said that Uniswap v3 seemed to be designed for professional market makers rather than passive DeFi liquidity providers. In addition, in a Tier 1 environment, gas costs associated with actively managing v3 positions can be very expensive.

summary

The above contents are the reasons why Uniswap V3 has increased the efficiency of liquidity providers, but still cannot avoid unpredictable losses. In addition, although some members of the DeFi community are disappointed with Uniswap v3, the main goal of Uniswap v3 is actually to provide the best price for traders.