From Uniswap V1 to V3: A Journey Through the Evolution of Decentralized Trading

6/22/2023 23:34

Since its development by Hayden Adams & the Uniswap Labs in November 2018, Uniswap has become the top Decentralized Exchange in the blockchain space amassing a Total Value Locked of $4.38bn and a volume of $614.78m (DeFiLlama), as of April 16, 2023. 
Uniswap sits on top of the food chain. However, it has evolved, adding new features through V2 and V3 version upgrades. In order to understand Uniswap and its potential benefits, we have to start with the basics.

What is Uniswap?

In simple terms, Uniswap is a decentralized exchange protocol built on the Ethereum blockchain that allows users to trade cryptocurrencies directly without needing an intermediary. It uses an automated market-making (AMM) system that allows anyone to add liquidity to the protocol and earn fees for facilitating trades. It’s open source, meaning data is stored in a transparent way, and UNI is its governance token allowing for community ownership. 

What is a decentralized exchange or DEX? 

First, let’s start with the opposite, centralized. A centralized exchange means all currency passes through a third party or middleman. Examples of centralized exchanges include Binance, Coinbase, and Kraken. 

A decentralized exchange is a marketplace that allows traders to buy and sell cryptocurrencies with one another without relying on intermediaries or third parties. These platforms utilize smart contracts, self-executing agreements written in code to facilitate secure and transparent transactions. 

Now, we have an idea of some of the basic concepts needed to dive deeper. Let’s journey back to the origins of Uniswap’s version 1.

V1: Igniting the flames of DeFi innovation

According to its whitepaper, the Uniswap protocol was designed with simplicity in mind and provides an interface for seamlessly exchanging ERC20 tokens on Ethereum. This eliminates unnecessary forms of rent extraction and middlemen, allowing for a faster, more efficient exchange. Where it makes tradeoffs… decentralization, censorship resistance, and security are prioritized. 

This ground-breaking innovation ushered in the automated market maker (AMM) model. Users could now trade, swap and provide liquidity without an intermediary, thus eliminating centralized exchanges' traditional central order books. Now, users can swap between ETH and ERC20 tokens with lower fees and transaction time.

V2. Doubling the impact

If the first was good, the second should be better. This was the case with the Uniswap V2; of course, it did not disappoint. It was a massive improvement from the previous version. Maintaining a constant market-making algorithm like Version 1 allowed liquidity providers to set their fees on trades and improved gas efficiency. Other newly added features include:

  • Price oracles: This was introduced to the protocol to enable tracking the average price of tokens in real-time to provide accurate prices for users.
  • ERC20/ERC20 swaps: In V1, swaps were between ETH and ERC-20 tokens. The V2 addressed this problem and lifted this restriction.
  • Flash swaps: Allows users to borrow tokens from a pool and pay it back in the same transaction if they provide liquidity in the same pool.

Why V3?

After updating it just a year prior, why the need for another upgrade? In March 2021, the V3 whitepaper was released. This came with a lot of buzz, enthusiasm, and some stir in the Uniswap community and the DeFi space in general. New key features were added to the protocol. These included;

  • Concentrated liquidity: Uniswap v3 introduced concentrated liquidity, which allows liquidity providers to concentrate their liquidity within a price range, resulting in lower capital requirements and potentially higher returns.
  • Multiple fee tiers: Multiple fee tiers, ranging from 0.05% to 1%, allows liquidity providers to earn higher returns for taking on greater risk.
  • Range orders: Users can specify a price range within which they are willing to trade, providing greater control and flexibility over the trading process.
  • Customizable price curves: It allows liquidity providers to customize the price curves of their pools, enabling them to optimize their returns based on their specific strategies.
  • Non-fungible liquidity: Uniswap v3 introduced the concept of non-fungible liquidity, which allows liquidity providers to mint unique tokens representing their specific positions in a liquidity pool.
  • Dynamic fee switching: This allows liquidity providers to switch between fee tiers dynamically, enabling them to adapt to changing market conditions.
  • Oracle upgrade: Users of Oracle no longer need to track previous values of the accumulator externally.

Despite these massive improvements and feature additions, the industry has had mixed reactions. Many believe that centralized liquidity always has a high potential for impermanent loss, and the liquidity provision strategy is more complex than previous versions, which could make it harder for new users to understand. Other arguments include the following;

  • Higher risk: By concentrating liquidity in a narrow price range, liquidity providers are exposed to greater risk if the market moves outside of that range. This can lead to lower returns or losses if the market conditions change unexpectedly.
  • Complexity: Centralized liquidity adds another layer of complexity to Uniswap, which could make it more difficult for new users to understand and participate in the platform.
  • Less liquidity across the entire price range: By concentrating liquidity within a narrower price range, less liquidity may be available in other parts of the price spectrum. This could lead to wider spreads and potentially less efficient price discovery.
  • Reduced flexibility: With centralized liquidity, liquidity providers have to choose a specific price range to concentrate their liquidity within, which can limit their ability to respond to market changes or adjust their liquidity provision strategy as needed.

Despite all these arguments against the Uniswap V3, other decentralized exchanges are beginning to adopt the central liquidity model approach in a bid to compete for users.

An example of such is Trader Joe, which according to reports from Messari, became the fastest-growing DEX within 180 days it introduced the liquidity book, which is its central liquidity model. Also, V3’s Business Source Licence (BSL) expired on April 1, 2023, after two years, thus making it possible for other DExs to fork and use it.

Ever since CamelotDEx and Paancakeswap have forked it, more are expected to follow suit. As of the time of writing on 16th April 2023, data sources from DeFiLlama show that the Total Value Locked lies at $233.65m, with a majority in Binance Smart Chain.

In conclusion, Uniswap v3 represents a significant evolution of the AMM model, with several new features and concepts aimed at improving capital efficiency, reducing slippage, and providing greater flexibility to liquidity providers and traders. While Uniswap v2 was a game-changer in its own right, the introduction of Uniswap v3 sets the stage for even greater innovation in the world of decentralized finance.

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