Original author: Kofi J
Original source: CoinGecko
Compiled by: BlockTurbo
Comparison of Uniswap V3 and Trader Joe AMM models
Uniswap V3’s centralized 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 select custom price ranges, while Trader Joe uses discrete “price buckets” to allow LPs to define fixed price ranges for precise deployment of liquidity.
Crypto markets trade around the clock and never take a break. The financial value of digital assets comes directly from user demand. Compared with traditional stocks and other assets whose valuation only depends on profits, the valuation of digital assets is more efficient.
However, capital efficiency in the DeFi space remains low for numerous reasons. The core reason for this inefficiency is the fragmentation of the DeFi ecosystem. This fragmentation does not only exist in a single chain, but also includes a two-tier system of centralized services and decentralized services. The landscape of DeFi is also constantly changing. Emerging protocols naturally start with inefficiencies and become more efficient over time; however, in the "financial Lego" system of DeFi, these inefficiencies often spread to other areas.
As DeFi grows and matures, these inefficiencies will naturally be addressed through the development of the protocol layer and the increasing number of arbitrageurs who play a vital role in the health and functionality of the ecosystem. Fill in the gaps and make money in the process.
Uniswap V3’s centralized liquidity model and Trader Joe’s liquidity book model provide good examples of protocol-level liquidity efficiency upgrades. In this article, liquidity efficiency will mean the optimal 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 an asset; how quickly an asset can be bought or sold without affecting the market price. The overall liquidity of cryptocurrencies has strengthened and grown tremendously. Compare Ethereum’s total market cap before the 2017 bull run to its market cap today:
In 2017, the market capitalization of Ethereum was $27,681,279,352, and the daily trading volume was $456,818,455;
The market capitalization of Ethereum in 2023 is $251,586,840,870, and the daily trading volume is $9,272,832,786.
Ethereum’s market capitalization has grown by more than 800%, and its daily transaction volume has increased by more than 1,000%. These trading volumes are still distributed across various centralized and decentralized exchanges. But overall, it is very obvious that the current market can more easily digest a $10 million Ethereum sell order than the 2017 market due to the increased liquidity depth.
Every transaction requires a counterparty: a buyer needs a seller, and a seller needs a buyer. 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, making profits by charging the so-called bid-ask spread.
A classic example of a market maker in the cryptocurrency space is Wintermute, who recently received 40 million ARB tokens for their market making activities. Market makers remain critical because low liquidity can lead to slippage, and if the execution price differs from the forecast price, traders will use another, more efficient service.
How the automated market maker (AMM) model works
Uniswap’s success came 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 purchasing the asset uses a liquidity pool as a counterparty, eliminating the need for an intermediary. The AMM model relies on incentivizing liquidity providers through transaction fees, while smart contracts rebalance the liquidity pool through a basic formula to keep the asset ratio constant: x*y=k.
Users provide liquidity in the form of LP tokens and participate in market making activities. This new model makes permissionless trading of digital assets possible.
Uniswap V3 Centralized Liquidity
Uniswap V3 was released in May 2021, introducing the concept of centralized liquidity. This model focuses on maximizing capital efficiency, resulting in better trade execution and increased fee income for liquidity providers. To learn more about Uniswap V3 and how to provide liquidity strategies, you can read our previous article: "Understand how to maximize profits through Uniswap V3 in one article."
The core innovation is to allow liquidity providers to choose custom price ranges: each liquidity provider has a custom price curve, and traders trade based on the sum of these price ranges.
As shown in the picture above, it is the liquidity pool of ETH-USDT. The complete price range is selected, reflecting the standard liquidity distribution in the V2 pool. Liquidity providers' capital is evenly distributed along the price curve, which has the advantage of being able to handle all price ranges from zero to infinity. However, given that the vast majority of trades occur within a narrow price range, much of this capital is not used and is therefore very inefficient.
In the example above, a custom price range for ETH-USDT has been selected. Liquidity providers will receive trading fees proportional to their liquidity contributions within a predefined range ($1,706 and $2,303). The majority of Ethereum transactions have occurred within this range in recent weeks, and this custom range will allow liquidity providers to earn a similar amount of transaction fees with far less capital than the V2 pool, or deploy the same amount of capital And earn more transaction fees. In both cases, it will be better for liquidity providers, thanks to increased liquidity efficiency.
Uniswap V3’s centralized liquidity pool is particularly beneficial for stablecoin pairs that trade within narrow ranges, with up to 99.95% of the liquid capital in these pairs never being used in V2.
Game theory comes into play in V3 pools, as users can choose where to allocate capital. Therefore, some providers will target an unlikely but more profitable range, given the higher share of liquidity provision within that range, while others will focus on a narrower range. This ensures that the price curve follows a reasonable distribution.
Overall, the V3 pool allows for greater liquidity depth, which means lower slippage for traders and less capital for liquidity providers to get the same trading fees. Second-order effects allow this saved capital to be put to productive use in other areas of DeFi. Centralized liquidity is a great example of how all users can benefit from protocol-level liquidity efficiency upgrades.
Trader Joe’s Liquidity Book
Many people know Trader Joe’s as the superstar DEX on Avalanche. However, Joe V2 quickly became one of the most popular decentralized exchanges on Arbitrum, gaining traction following the ARB airdrop and massive trading volumes. Trader Joe's new liquidity book model is driving this growth.
What are Bins (price bins) in the Trader Joe's liquidity book model?
Understanding Bins (price bins) is critical to understanding the liquidity book model. In the Trader Joe V2 pool, liquidity is deposited into different price bins. Each box has a fixed price, and liquidity is put into these different boxes.
Users trading within a box receive a fixed price as long as the trade remains within the box's bounds, meaning there is no slippage and extremely price efficiency. All boxes are stacked together to provide deep liquidity, and liquidity providers can choose to create different liquidity price box distributions to create more advanced strategies.
Liquidity Book Model
The Liquidity Book Model is a new instance of the Automated Market Maker (AMM) model that significantly improves liquidity efficiency and provides users with more flexibility when providing liquidity. For example, they can place bets when entering and exiting positions without paying multiple exchange fees and earn transaction fees.
Similar to the Uniswap V3 pool, the liquidity book model allows for centralized liquidity and allows liquidity providers to customize price ranges. Liquidity is no longer evenly distributed along the price curve, but is deployed precisely to achieve greater transaction fee income. It also has the added advantage of handling larger trading volumes with less liquidity than typical liquidity pools. Simply put, a liquidity book can serve a large number of traders with minimal liquidity. This model moves away from the increasingly archaic paradigm of relying on attracting large amounts of captured liquidity to provide efficient prices.
Thanks to the liquidity book model and the "price boxes" it uses, traders can enjoy zero-slippage trading. Each box is a single price point, and Trader Joe’s aggregates all of these boxes into a single liquidity pool. "Active Bins" contain both tokens in a pair and determine the asset's current market value. "Active Bins" is the only box that earns transaction fees, and transactions conducted in this box have no slippage. The introduction of bins even upgrades the centralized liquidity of Uniswap V3, as bin precision and liquidity are more concentrated at more narrowly defined price points.
When all the liquidity in a box is used up, the price moves to the next box. This dynamic structure is a key feature of the liquidity book model. This model flexibly adjusts liquidity distribution to make trading more efficient. Different boxes provide liquidity within specific price ranges, allowing for rapid adaptation to market demand when needed. This dynamic structure helps reduce slippage and provides traders with better execution prices.
The image above shows the liquidity provider options when using the Trader Joe V2 pool: Spot, Curve, Bid-Ask, and Wide.
Here is a simple example of how to take advantage of 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 price of ETH rises and gradually moves through the boxes, users will gradually sell ETH and receive USDC. In the example above, the price range selected is relatively small, but users can choose any price target they want, which is an easy way to gradually sell an asset.
Vice versa; users can utilize the liquidity book model to unilaterally supply ETH below the current market price through a reversal process to purchase in batches. By using both apps in the Spot shape, users can buy or sell over time in a single transaction and earn exchange fees in the process.
Spot shapes provide liquidity providers with incredible freedom and flexibility in deploying liquidity. The lower the number of boxes, the more concentrated the liquidity; therefore, the greater their share of revenue from all transactions in this range. At the same time, if the price exceeds this range, liquidity providers face the greatest risk of impermanent losses.
Liquidity providers can observe where other market participants deposit liquidity on Trader Joe’s, and the chart above shows the current liquidity distribution for ETH-USDC.
The image above shows several strategies outlined by Trader Joe, allowing users looking to provide liquidity to choose the shape that best suits their goals. Users are strongly recommended to start with test funds and gradually understand how the liquidity book model works before committing full funds.
In summary, the liquidity book model provides a new level of flexibility in liquidity provision, reduces slippage, and allows for more dynamic liquidity rebalancing, essentially opening up new levels of flexibility for traders and liquidity providers within DeFi. new paradigm.
Disadvantages
impermanent loss
Impermanent losses are the biggest danger any liquidity provider faces. Simply put, impermanent loss is the difference in value between when an asset is deposited and when it is withdrawn. When asset prices move significantly, liquidity providers face losses but hope that transaction fees will make up for this. In many cases, it may be more profitable for investors to hold tokens in wallets rather than provide liquidity.
In both models, liquidity providers face a greater risk of impermanent losses than traditional pools because liquidity is spread over a narrower range. Impermanent losses occur when asset prices exceed a specified range; the smaller the range, the greater the chance of impermanent losses. But in exchange for this higher risk, liquidity providers have the opportunity to earn more transaction fees, which is a typical scenario where risk and reward rise in parallel.
One might argue that since Trader Joe's liquidity book model allows for more specific liquidity provision, liquidity providers would face the greatest potential for impermanent losses in these pools. However, Trader Joe's introduced a volatility accumulator that gauges volatility by monitoring bin changes. When volatility rises, the volatility accumulator automatically increases exchange fees, helping protect liquidity providers from impermanent losses.
Complexity
Both Uniswap’s V3 pool and TradeJoe’s liquidity book model enable a more centralized liquidity supply, resulting in higher transaction fees for liquidity providers and better trade execution and lower costs for traders. slippage. However, both are more complex than the liquidity provision many crypto users are used to. This additional complexity can lead to more serious user errors, so it's important to do trial and error with each model
Specific to the liquidity book model, liquidity providers are only limited by their imagination. However, in times of market volatility, they can easily be pushed out of their boxes, resulting in impermanent losses and the need for a more active management style. However, the nuances and complexities involved form part of the rewards of this new era of liquidity provision.
Competition will drive growth and benefit DeFi
On the face of it, Uniswap’s V3 pool is more user-friendly than Trader Joe’s liquidity book model. But in terms of liquidity efficiency, the liquidity book model surpasses the V3 pool. If done correctly, the extreme flexibility offered by price boxes makes liquidity provision more attractive and profitable.
The new level of capital efficiency introduced and fostered by both pools has a positive impact on 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 DeFi protocol level is imperative.
(The above content is excerpted and reprinted with the authorization of partner MarsBit, original text link | Source: BlockTurbo)
Statement: The article only represents the author's personal views and opinions, and does not represent the objective views and positions of the blockchain. All contents and opinions are for reference only and do not constitute investment advice. Investors should make their own decisions and transactions, and the author and Blockchain Client will not be held responsible for any direct or indirect losses caused by investors' transactions.
This article DEX Liquidity Battle: Uniswap V3 vs. Trader Joe, who will win? First appeared in Block Guest.
