Home » Advantages of Uniswap v3 Liquidity Providing
Uniswap v3 allows you to earn more LP fees than v2 by providing liquidity in a narrower range.
In Uniswap v2, liquidity is distributed evenly along an x*y=k price curve, with assets reserved for all prices between 0 and infinity. For most pools, a majority of this liquidity is never put to use. As an example, the v2 DAI/USDC pair reserves just ~0.50% of capital for trading between $0.99 and $1.01 , the price range in which LPs would expect to see the most volume and consequently earn the most fees.
V2 LPs only earn fees on a small portion of their capital, which can fail to appropriately compensate for the price risk (“impermanent loss”) they take by holding large inventories in both tokens. Additionally, traders are often subject to high degrees of slippage as liquidity is spread thin across all price ranges.
In Uniswap v3, LP’s can concentrate their capital within custom price ranges, providing greater amounts of liquidity at desired prices. In doing so, LPs construct individualized price curves that reflect their own preferences.
Therefore, those who want to earn fees will provide liquidity in the price range close to the current price. As a result, liquidity often draws a mountain-like shape around the current price, as shown in the following figure.
What’s more, compared to liquidity on v1 & v2, which is always spread across [0,∞], liquidity on v3 can be concentrated within certain price ranges and thus results in highercapital efficiency from traders’ swapping fees.
Let’s say if I provide liquidity in the range [1200, 2800], the capital efficiency will then be 5.24x higher than v2 with the range [0,∞] Uniswap has created a capital efficiency comparison calculator that is fun to play around with as it compares v3 positions to v2 positions.
If market prices move outside an LP’s specified price range, their liquidity is effectively removed from the pool and is no longer earning fees. In this state, an LP’s liquidity is composed entirely of the less valuable of the two assets, until the market price moves back into their specified price range or they decide to update their range to account for current prices.
Many investors are attracted to the idea of using an auto rebalancing strategy on their LP in order to keep in their positions inside the liquidity range and maximize the fees they receive. However, such strategies increase complexity, by introducing path dependence as well as additional gas fees and operational risk. Hence they have been met by incomprehension and caution by some members of the DeFi community.
How to rebalance
There are two ways to rebalance: passive rebalancing and active rebalancing.
“Active rebalancing” is a method of providing liquidity in a new range by swapping tokens to be managed during rebalancing. The downside is that there is a small swap fee for each rebalancing.
On the other hand, “Passive rebalancing” does not swap tokens at the time of rebalancing but provides as much liquidity as possible within a larger range, and then provides the additional tokens as single-sided liquidity. This “single-sided liquidity” is placed close to the current market price so that if the price moves in this direction, the second position also becomes active and collects LP fees.
For example, the following diagram illustrates how liquidity is provided by 1 ETH and 2000 USDC when there are 2500 USDC and 1 ETH under the control of manager, and how single-sided liquidity is provided by the surplus 500 USDC.
When the price of ETH fluctuates between 2000USD and 1750USD, the single-sided liquidity part functions to convert the surplus USDC into ETH gradually.
It has the advantage of no fees when rebalance. However, LP fees you get will decrease compared to active rebalancing if the market continues to fluctuate to either bull/bear for a long time (because the single-sided liquidity won’t work & the liquidity of the two-sided portion will also decrease).
How to choose the range
How to choose the range in rebalancing is even more important than the method of rebalancing.
When considering LP income, the best range is as tight as possible to the future range of prices. (Which is unknown)
When only considering the objective to decrease IL, it is optimal to make the range as wide as possible, as with v2 LP.