Uniswap v3 Is the Perfect Market Maker for Venture Capitalists

Uniswap’s key feature increases the gamification of the most popular DEX. But this is a game retail doesn’t have the tools to win.

After announcements of announcements, the world was finally able to see Uniswap’s plans for its third version. Given that the project’s second version was one of the catalysts for DeFi’s meteoric rise in 2020, the anticipation for this release has been met with similar excitement. Indeed, Uniswap has regularly been at the forefront of innovation, especially for automated market makers (AMMs). 

Automated market makers are the cornerstone of decentralized finance. To understand how revolutionary these are, one must first understand market-making functions in traditional finance. 

Market makers offer assets at two prices, one for sellers and one for buyers. It profits from the spread between these two numbers. The real business of market makers is not price; it’s volume. The higher the volume, the higher the profit.

Due to the sheer amount of any singular asset needed, only institutions can be market makers in traditional finance. Even popular brokers like Robinhood rely on market makers to provide sufficient liquidity. This allows financial institutions to ever-so-slightly bend the rules of the game, if not directly change them for their own interests or those of their business partners. 

Since January, this has been a highly debated topic when retail investors accused Robinhood and market makers of market manipulation.

Being the market maker confers undeniable advantages, and the invention of AMMs in DeFi has been a game-changer. Suddenly, everyone could be the market maker. Any liquidity provided to facilitate trades decreased the ask-bid spread, reduced slippage, and earned fees for the liquidity providers (LPs). The best part was that the liquidity pool is liquidity-agnostic; it doesn’t matter if one LP has invested millions in the pool or just a couple thousand dollars. 

LPs are rewarded proportionally to their participation, but no one is excluded from market-making.

By automating the process of market-making, AMMs provided equitable opportunities to all market participants. With v3, however, this has changed dramatically.

One of the most impressive new features of Uniswap v3 is the possibility for LPs to provide liquidity within a specific price range. For example, while Alice provides liquidity to the entire DAI/USDC trading range, Bob can only provide liquidity to trades between 0.9-1.1DAI/USDC. 

This means that Bob’s capital, as it is concentrated in just that range, will be more efficiently used in any trades between these two values.

In essence, if Alice and Bob have the same amount of capital but Bob concentrates his capital in a  certain range around the current price, he will earn more in fees than Alice. The narrower the range at which Bob sets his liquidity, the more he will earn from fees than Alice as long as the price trades in that range. Alice’s strategy will shine if the price leaves that range as she will then earn all of the fees while Bob’s liquidity sits idle.

This also has a very positive effect on slippage, which effectively decreases as more capital is available around the current price rather than idle at both ends of the price curve. This decreases the price impact of any single transaction, so users effectively have a better rate than they would if there was less liquidity close to the current price.

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Uniswap v3 provides the only possible "solution" to impermanent loss and price impact

It also lets you reduce total price risk while increasing your impermanent loss (relative to v2) with concentrated liquidity

This might need a blogpost but I'll try a long thread first

— Hayden Adams