Liquid Competition: Uniswap v3 Fees and the Race to the Bottom
The 0.05% Tiers are Coming!
As I’ve written about previously (Crypto Analytics: Exploring Uniswap v3 Data), Uniswap v3’s innovations brought more customization, aimed at greater capital efficiency for liquidity providers, and better prices for traders.
In v2, every pool had a 0.3% fee rate and each liquidity position supported the range of potential prices ($0 to $infinity). So the only way that liquidity providers (LPs) could compete for fees was to pour in more funds into the pool. The only power needed to compete was scale. But, Uniswap v3’s features introduced two new vectors to compete on:
Custom Liquidity Ranges: Liquidity Providers (LPs) could choose the price range that they wished to support. For example, rather than $0 to $infinity, I could pick $50-$100. With custom liquidity ranges, each LP could compete on providing a more accurate range than other participants.
Multiple Fee Tiers: Rather than being locked to a 0.3% take rate, LPs could choose to create their pools with either a 1%, 0.3%, or 0.05% fee per trade. With multiple fee tiers, LPs could compete by offering the best price for each trade.
We’re going to focus on fee tiers today, because that’s where the action has been.
Competing on Price
If you shop on an ecommerce marketplace, you’ll see price competition everywhere. Sellers who charge the lowest price for an item will win the sale, and sales are money in their pocket. A savvy seller might look a best seller list, grab the top few SKUs, and list them at a lower price. They sacrifice a bit of profit for each unit in the short-term, but the bet is that over time they’ll wind up being more profitable because of the extra demand.
So now, let’s carry that framework over to Uniswap LPs. At the time of writing, the USDC/ETH 0.3% pool was the most traded pair on Uniswap v3 by a pretty wide margin, almost 4x volume of the next most traded pool. This pool was also the most saturated with over $400M deposited (Total Value Locked - TVL). So if you’re someone like me, who is far from operating on the scale of millions, but wants to take part in the upside: Where might you look for opportunity?
You lower your prices.
From May 30th - June 2nd, 2021 TVL for USDC/ETH at the cheaper 0.05% fee tier ~15x’d from $700k to $10M. Once the supply was there, like any good marketplace, the demand followed. At its June 2nd peak, that $10M of liquidity supported $80M in trading volume (8x Volume/TVL), whereas the $400M of liquidity at the higher priced 0.3% tier supported $320M in trading volume in the same period (< 1x Volume/TVL).
The lower priced tier hasn’t completely take over just yet, but it’s coming.
It’s also more profitable.
In the ecommerce seller example, lowering prices was a risk that only paid off if it drove enough extra sales. This risk is present in the USDC/ETH 0.05% liquidity pool as well. LPs are slashing their take rate by 1/6, but have so far improved their capital efficiency by up to 8x. While the pool is still ramping up, LPs who are willing to cut their prices are netting a higher return (79% APY at 0.05% vs 58% APY at 0.30%).
So if you want to deposit into a Uniswap v3 liquidity pool, what do you do with this information? Do you optimize for a higher take rate, and stick with the 0.3% tier? Or do you undercut your competition, swallow the 1/6 cut, and chase extra volume at the 0.05% tier? That’s up to the individual and the market to decide (not financial advice), but would you rather be the disruptor or wait and hope to not be disrupted?
The first move has already been made, and other pairs are following. Shortly after the USDC/ETH TVL jump, the TVL for USDT/ETH (2nd most popular ETH pair) at 0.05% doubled, and WBTC/ETH (4th most popular) ~300x’d!!! DAI/ETH was the 3rd most traded ETH pair, but 0.05% TVL hasn’t taken off… yet
In the long-term, I wouldn’t be surprised to see the 0.05% tier’s volume flip the 0.3% tier for the most popular pairs. The 0.3% tier could flip the 1% tier for fringier pairs as well, which could also eventually make their way to 0.05%. Outside of the crypto world, we know that competition benefits the end consumer. Now, we’re seeing it play out in Uniswap. Greater competition among LPs drives better prices for traders, which brings more trading demand to Uniswap, which then attracts more LPs and more competition, which drives better prices for traders. The flywheel spins.
Well, the flywheel spins to a certain point (for now). Once you get down to the 0.05% fee tier, there’s nowhere else to go. At that point, the benefits of scale, and being able to actively pick the most accurate price range, are how LPs differentiate themselves and compete for fees. So, in order to keep the growth flywheel spinning, and even make it spin faster, we can look for more areas where LPs can differentiate themselves from their competitors:
Fee tiers: Offering multiple fee tiers was a new innovation for Uniswap v3, and now that we’re seeing it in action, we can think about what’s next. As the market develops, there should be some optimal fee tier where the demand from traders and return for LPs evens out. Maybe the ideal market fee rate is somewhere between 0.3% and 0.05%? Maybe it’s less than 0.05%? Now that we know fee tiers work, the next step could be to make them more flexible.
Incentives: What else could an LP offer to incentivize traders to trade with their liquidity? Today, traders don’t know what liquidity they’re trading with, but imagine one day they could. Maybe I provide liquidity at the 0.05% fee tier, but I also give 0.01% back in some token? This could be in Uniswap’s UNI tokens, or maybe some LPs are other businesses or protocols and have their own token to offer? Then, traders might not just want the best price, but on the best rewards as well. Balancer, a Uniswap competitor, already offers traders BAL tokens equivalent to gas fees for each trade, and (back to ecommerce) retailers have offered loyalty programs to attract and retain customers forever. What other value could be offered to traders once prices level out?
I’m looking forward to seeing what comes next. But until then, the 0.05% tier is coming.
I’ve been working on crypto analytics part-time for the past month, and I’m looking to do more. You can reach out to me on Twitter @MSilb7 with any opportunities or requests.
This was part of the second analysis I created with Gamma Strategies, click here to see the dashboard.
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