DeFi bucks crypto market correction as Uniswap v3 leads the charge

Decentralized exchange Uniswap successfully launched version 3 of its platform in May — resulting in high trade volumes despite a downturn across the cryptocurrency markets.

The latest version of the hugely popular decentralized finance (DeFi) automated market maker (AMM) has quickly attracted a sizable amount of trade volume, seeing it move into the top five decentralized exchanges alongside Sushiswap, PancakeSwap v2 and its predecessor, Uniswap v2.

The success of v3 cannot be understated, as the cryptocurrency space has been under pressure due to a market correction in May that has cast shadows over what has been the most prolific bull run that the space has seen.

Uniswap v3 is now the leading dex in terms of trading volume, recording an average of $1.2 billion in daily transaction volume, while Uniswap v2, which was leading until very recently, currently processes just under $1 billion in 24-hour transaction value.

Furthermore, a number of fellow DeFi tokens led a rally in the markets after last week’s tumultuous correction, which has since been dubbed the biggest capitulation in the cryptocurrency markets. However, the overall market saw a $400 billion increase in value shortly after as several altcoins surged, with Maker’s MKR token gaining 91% and Yearn.finance’s YFI seeing a 72% increase. The native token of the Uniswap exchange, UNI, and AAVE also saw significant increases in value.

As a result, some analysts believe that Uniswap v3 could see increased use by liquidity providers and retail users given its improved functionality. But what changed, and is it ready to replace the previous version?

Uniswap v3 revisited

The nature of software development means that applications and platforms are in a constant state of improvement, and Uniswap is no exception. The first version of the booming DeFi AMM was released back in 2018 and has garnered thousands of users and hundreds of millions of dollars worth of transaction volume in the three years since.

Given the nascent state of the DeFi ecosystem, changes come quick and fast, and developers are constantly looking to improve current protocols and offer new products and services on their platforms.

Uniswap v2 was launched in May 2020 and introduced direct token swaps and other features that improved the overall performance of the AMM. In the year since, Uniswap has facilitated around $135 billion in trading volume and has established itself as one of the biggest cryptocurrency spot exchanges worldwide.

While the platform continued to contribute significantly to the popularity and use of DeFi, developers began work on Uniswap v3 behind the scenes, introducing improved control for liquidity providers on the platform and multiple fee tiers.

V3 is a success?

Uniswap v3’s launch in May has been heralded as a success, with the trading volume on the platform racking up some eye-popping numbers despite its inferior total value locked (TVL) compared with Uniswap v2.

Johannes Jensen, product and project manager at eToro, told Cointelegraph that the improvements made to critical issues existing in the designs of constant function market makers (CFMMs) have been a key driver in the immediate success of Uniswap v3:

“The primary contribution is the ability for liquidity providers (LPs) to offer bounded liquidity in a certain price range. With the custom liquidity provision feature, trading fees are collected and held separately, rather than automatically reinvested as liquidity in the pool. An interesting consequence of bounded liquidity positions is that the systemic implications of LP shares are inherently mitigated.”

Jensen noted that Uniswap’s v2 model essentially gave liquidity providers proportional ownership of a liquidity pool, which created a complex payout function due to impermanent losses, making the feature more similar to an options contract than a direct claim to the underlying asset.

Elias Simos, protocol specialist at Bison Trails, believes that the early success of Uniswap v3 and its innovations will continue to attract capital from liquidity providers given its improved efficiency:

“With Uniswap V3, we are seeing the emergence of capital-efficient DeFi. For reference, since its launch in early May, Uniswap V3 has ended up printing something like 120% TVL utilization vs Sushi trading at 20%.”

Aniket Jindal, co-founder of transaction infrastructure firm Biconomy, highlighted the fact that despite high fees, Uniswap v3 has attracted new users, which suggests that the improvements brought by the latest version of the AMM have been met positively: “What’s even more surprising is even after gas prices went up to insane levels, Layer 2 DEXs became more popular.”

Liquidity providers chase improved returns

The cryptocurrency ecosystem has become accustomed to things moving at breakneck speed, and the prospect of bigger, better returns could well be the catalyst to drive more liquidity providers to Uniswap v3.

Simos believes that the inherent complexities of moving across to v3 will be a short-term barrier to entry, but the bottom line, better yields and new products will drive the migration to the newest version of the AMM:

“Yes, concentrated liquidity provides new challenges, perhaps even more overhead for LPs, but firstly the yield is better, and secondly there will soon be an ecosystem of products around Uniswap V3 LP positions that will abstract some of the complexity away.”

While Jindal agreed with Simos’ sentiments that v3 could continue to attract liquidity providers, there are some factors that might create some friction in the migration of users from v2 who will have to reapprove their tokens for v3 and also for “liquidity providers who now need to select a ‘price range’ which can be complicated for many to understand.”

Jensen believes that the increased capital efficiency of the Uniswap v3 model will continue attracting new liquidity providers and traders: “The ability to provide bounded liquidity for a desirable price-range becomes an interesting tool in volatile markets, as LPs can use the model to price the inventory risk of holding less-known or volatile assets.”

Related: Uniswap v3 hopes to reinvent its DEX, others see a different path for DeFi

As a consequence, Jensen suggested that liquidity providers using specialized CFMMs like Curve might migrate to Uniswap v3, depending on the relative depth of stablecoin pairs and trading activity in competing pools. He also added that some might not necessarily want to deal with the added demand of managing their risk:

“Maintaining a consistent income during volatile markets with Uniswap V3 will require an active effort from LPs, as they will need to adjust their pricing ranges accordingly. Decidedly passive LPs may opt for lower capital efficiency to reduce the chance of suffering impermanent losses in highly volatile markets.”

DeFi powers the comeback

2021 has proven to be another monumental year for the cryptocurrency space, with major moves happening across the ecosystem. DeFi has become a major focal point, and the most recent market correction has added credence to DeFi’s influence and role.

Nevertheless, Simos highlighted the fact that DeFi has seen prolific growth since the beginning of 2020 and that important data shows that: “DeFi has been printing positive signs for over 1.5 years right now. The growth in fundamentals (TVL, volumes, users) continues to be on a hockey stick trajectory. [...] Will there be short-term volatility? For sure. But the fundamentals persist.”

Jensen pointed to the role that DeFi and AMMs are playing in capital allocation from liquidity providers and their general use by everyday cryptocurrency users, so much so that they have “increasingly become an intrinsic part of how capital is allocated in crypto today.”

He also highlighted the yin-and-yang relationship of DeFi and Ethereum, with the latter still the smart contract blockchain of choice for the space. This has inevitably led to problems around high fees, but Jensen believes v3 could help alleviate some of these pain points while Ethereum continues its evolution toward a proof-of-stake future:

“Uniswap V3 may attract a more sophisticated breed of LPs which will build new features for algorithmically adjusting price-ranges based on market volatility or even sentiment data.”