Fundamental Insights
As a leader in AMM, Uniswap V3 offers a new solution for improving capital utilization. This article briefly discusses the solution.
The AMM algorithm of Uniswap V3 is improved from xy=k in V2 to the above form. where Pa, Pb represent the upper and lower bounds of Token1 to Token0 prices, respectively, and L represents the liquidity provided. Concentrated liquidity means that LP can concentrate the liquidity in the (0,∞) price range provided in V2 version in the range [Pa,Pb], thus improving the efficiency of the fund.
As shown above, the liquidity calculation curve in V3 is actually Virtual reserves, and the real liquidity curve is shown in orange.
What are the specific changes brought by the new algorithm in V3?
For users
Reduced slippage
For users, the most significant aspect of V3 is that there is less slippage for the same amount of liquidity. This change can be understood visually with the following graph.
In AMM’s algorithm, the price of a point is p = y/x for different curves, and the slippage Δp is the price difference before and after the trade, i.e. Δp = |p-p’|. Substituting x,y, it is easy to verify that there is no slippage when trading on the line x+y = k in the AMM algorithm. And for the curve in V3, the following result can be obtained from the derivation in the V3 white paper.
From the above result, it is easy to see that the larger L is, the smaller Δp is when Δy remains constant. To understand the problem more intuitively, it is easy to see that for the same volume, the larger k is, the “straighter” the part inside [Pa,Pb] is, and the smaller the slippage is.
In order to reduce the slippage, except Curve and DODO have made corresponding attempts, among which Curve’s solution is simple and brutal, replacing one segment of the curve with x+y = k. Therefore, we will not discuss it too much here. DODO proposes the PMM (Proactive Market Maker) solution, the core logic of which is to obtain the market price from the prognostic machine and adjust the AMM curve to obtain a smaller slippage. The following figure shows.
However, this scheme to reduce the slippage is only valid for the case where the price is obtained from the outside when for pairs where the main trading volume is on DODO, in its scheme will be k = 1, then the slippage will be the same as the algorithm for xy=k.
For Uniswap V3, the user slippage is smaller even for Uniswap pairs with the same liquidity, since the liquidity is centralized and implemented through Oracle.
For LPs
More flexible liquidity provision options can be created
In Uniswap V2, LP does not have much room for manipulation, only the option to inject or propose mobility. In V3, LPs have more room to operate and can build different liquidity strategies by setting different price ranges and liquidity. In fact, the current algorithm of V3 can be seen as a **generic solution** for xy=k and the traditional order book. When the price range is set to (0,∞), it is the xy = k solution, while when the price range is set to 1 tick (tick is a concept proposed in the Uniswap V3 whitepaper), it is **more like the order book’s pending orders**. However, due to the high cost of Ethernet Layer1 Gas, LP is currently unable to adjust the strategy for high frequencies due to cost considerations. When V3 is deployed on Layer2, there is an opportunity to see more sophisticated liquidity provisioning strategies under the new algorithm.
Will likely face greater impermanent losses
Concentrated liquidity is more of a double-edged sword, increasing asset utilization while amplifying the LP’s impermanent loss. When providing liquidity in the xy = k scenario, one asset in the liquidity pair is almost entirely swapped for another only when prices deviate significantly. In V3’s algorithm, when the market price deviates from the price range set by the LP, one asset in the LP is replaced with another. Therefore, for LPs, the invariant loss will be an important consideration when setting the liquidity provision strategy in the future.
In addition to the changes brought about by the centralized liquidity algorithm, Uniswap V3 also provides improvements in NFT LP Token, fees, Oracle, governance, etc., which are not discussed in this paper. In terms of pure AMM algorithms, Uniswap V3 offers a whole new way of thinking for the industry, and we look forward to seeing more sophisticated liquidity provisioning strategies on Layer2!
