DEX Liquidity Battle: Uniswap V3 and Trader Joe, who will win?

Comparison of Uniswap V3 and Trader Joe's AMM Model

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 Provider(LPs) to choose custom price ranges, while Trader Joe uses discrete "price buckets" to allow LPs to define fixed price ranges for precise Liquidity deployment.

Crypto markets trade around the clock and never rest. The financial value of digital assets is directly derived from user needs. Compared with the valuation of assets such as traditional stocks, which only depends on profits, the valuation of digital assets is more efficient.

However, capital efficiency in the DeFi space remains low for a number of reasons. The core reason for this inefficiency is the fragmentation of the DeFi ecosystem. This fragmentation not only exists in a single chain, but also includes a two-tier system of centralized services and decentralized services. The state of DeFi is also constantly changing. Emerging protocols naturally start out inefficient and become more efficient over time; however, in DeFi's "financial Lego" system, these inefficiencies often spill over into other areas.

As DeFi develops and matures, these inefficiencies will naturally be addressed through protocol layer development and a growing number of arbitrageurs, who play a vital role in the health and functionality of the ecosystem, Fill in the blanks and profit in the process.

Uniswap V3's centralized Liquidity model and Trader Joe's Liquidity book model provide good examples for upgrading Liquidity efficiency at the protocol level. In this paper, Liquidity efficiency will mean optimizing the utilization of currently available capital as much as possible.

What is Liquidity and How to Understand AMM(Automatic Market Maker) Model

The word 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 been strengthened and has grown tremendously. Compare Ethereum's total market cap before the 2017 bull run to today's market cap:

• In 2017, the market value of Ethereum was $27,681,279,352, and the daily trading volume was $456,818,455;
• The market cap of Ethereum in 2023 is $251,586,840,870 with a daily trading volume of $9,272,832,786.

Ethereum’s market capitalization has grown by over 800%, and its daily transaction volume has increased by over 1,000%. These volumes are still distributed across various centralized and decentralized exchanges. But in general, compared with the market in 2017, the current market is more likely to digest the $10 million Ethereum sell order due to the increase in Liquidity depth, which is very obvious.

Every transaction needs a counterparty: buyers need sellers, and sellers need buyers. Centralized exchanges use an order book model to match buyers and sellers. Centralized exchanges also rely on market market makers (MMs) to provide deep Liquidity on both sides, profiting by charging so-called bid-ask spreads.

A typical 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 are still critical because low Liquidity can lead to slippage, and if the execution price differs from the predicted 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 that has become the blueprint for every decentralized exchange since.

Unlike connecting two traders, a trader buying an asset uses a Liquidity pool as a counterparty without an intermediary. The AMM model relies on incentivizing Liquidity Provider through transaction fees, and the smart contract rebalances 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 it possible to trade digital assets without permission.

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 Provider. To learn more about Uniswap V3 and how to provide Liquidity strategies, you can read our previous article: "How to Maximize Profit Through Uniswap V3 in One Article" .

The core innovation is to allow Liquidity Provider 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 figure 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 Provider' 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 unused and therefore very inefficient.

In the example above, a custom price range of ETH-USDT has been selected. Liquidity Provider will receive proportional transaction fees based on their Liquidity contribution within a predefined range ($1,706 and $2,303). In recent weeks, the majority of Ethereum transactions have occurred within this range, and this custom range will allow Liquidity Provider 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 Provider, thanks to the increased efficiency of Liquidity.

Uniswap V3’s centralized Liquidity pools are especially beneficial for Stablecoin pairs that trade within tight ranges, and in V2 as much as 99.95% of the Liquidity capital in these pairs was never used.

Game theory works in V3 pools because users can choose where to allocate their capital. As a result, some providers will target the less likely but more profitable range, given the high percentage 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, V3 pools allow for greater Liquidity depth, which means lower slippage for traders and less capital for Liquidity Provider to get the same transaction 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 Liquidity efficiency upgrades at the protocol level.

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 after the ARB AirDrop and massive trading volume. This growth was fueled by Trader Joe's new Liquidity book model.

What are Bins (Price Bins) in the Trader Joe's Liquidity Book Model?

Understanding Bins (price boxes) is critical to understanding the Liquidity book model. In a Trader Joe V2 pool, Liquidity is deposited into different price boxes. Each box has a fixed price, and Liquidity is put into these different boxes separately.

Users who trade within a box receive a fixed price as long as the trade remains within the box, meaning no slippage and extremely price efficient. All boxes are stacked together to provide deep Liquidity, and Liquidity Provider 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, which significantly improves Liquidity efficiency and provides users with more flexibility when providing Liquidity. For example, they can achieve fixed 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 Liquidity to be pooled, allowing Liquidity Provider to customize price ranges. Liquidity is no longer evenly distributed along the price curve, but precisely deployed to achieve greater transaction fee income. It also has the added advantage of handling larger volumes with less Liquidity than typical Liquidity pools. In short, a Liquidity book can serve a large number of traders with minimal Liquidity. This model moves away from the increasingly archaic model of relying on attracting large amounts of captive Liquidity to deliver 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 pools all of these boxes into one Liquidity pool. "Active Bins" contain both tokens in the pair and determine the current market value of the asset. "Active Bins" is the only box that earns transaction fees, and transactions made in this box have no slippage. The introduction of bins even upgrades Uniswap V3's centralized Liquidity, as the precision of bins and Liquidity are more concentrated at more narrowly defined price points.

When all 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 transactions more efficient. The different boxes provide Liquidity within a specific price range, enabling rapid adaptation to market demand when required. This dynamic structure helps reduce slippage and provides traders with better execution prices.

The figure above shows the options for Liquidity Provider when using the Trader Joe V2 pool: Spot (spot), Curve (curve), Bid-Ask (ask spread) and Wide (wide).

Here is a simple example of how to take advantage of the Spot shape distribution:

In this ETH-USDC pool, Liquidity Provider can choose a range higher than the current market price and only provide ETH to the pool. As the price of ETH rises and gradually passes through the boxes, users will gradually sell ETH and get USDC. In the example above, the selected price range is relatively small, but users can choose any price target they want, which is an easy way to gradually sell an asset.

And vice versa; users can use the Liquidity book model to unilaterally supply ETH below the current market price through the reversal process to buy in batches. By using these two applications in the shape of Spot, users can gradually buy or sell in one transaction, and earn exchange fees in the process.

The Spot shape gives Liquidity Provider incredible freedom and flexibility in deploying Liquidity. The lower the number of boxes, the more concentrated the Liquidity; thus, the greater their share of revenue from all transactions in this interval. At the same time, if the price exceeds this range, Liquidity Provider face the greatest risk of Impermanent Loss.

Liquidity Provider can observe where other market participants have deposited Liquidity on Trader Joe, and the graph above shows the current Liquidity distribution for ETH -USDC.

The chart above shows several strategies outlined by Trader Joe's, and users looking to provide Liquidity can choose the shape that best suits their goals. It is strongly recommended that users start with test funds and gradually understand how the Liquidity book model works before investing all their funds.

In summary, the Liquidity ledger model provides new levels of flexibility for Liquidity provisioning, reduces slippage, and allows for more dynamic Liquidity rebalancing, essentially opening up new possibilities for traders and Liquidity Provider within DeFi. paradigm.

disadvantage

Impermanent Loss

Impermanent Loss is the greatest danger any Liquidity Provider faces. In simple terms, Impermanent Loss is the difference in value between depositing an asset and withdrawing it. Liquidity Provider face losses when asset prices move wildly, but hope that transaction fees will make up for this. In many cases, it may be more profitable for investors to keep tokens in a wallet rather than provide Liquidity.

In both models, Liquidity Provider face a greater risk of Impermanent Loss than traditional pools because Liquidity is spread over a narrower range. An Impermanent Loss occurs when the price of an asset falls outside a specified range; the smaller the range, the greater the chance of an Impermanent Loss. But in exchange for this higher risk, Liquidity Provider have the opportunity to earn more transaction fees, which is a typical scenario where risk and reward rise in parallel.

One might think that since Trader Joe's Liquidity book model allows for more specific Liquidity provisioning, Liquidity Provider would face the greatest potential for Impermanent Loss in these pools. However, Trader Joe's introduced a Volatility Accumulator, which measures volatility by monitoring bin changes. Volatility accumulators automatically increase exchange fees when volatility rises, helping to protect Liquidity Provider from Impermanent Loss.

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 Provider and better trade execution and lower liquidity for traders. of slippage. However, both are more complex than the Liquidity provision many crypto users are accustomed to. This additional complexity can lead to more serious errors by users, so trial and error with each model is important

Specific to the Liquidity ledger model, Liquidity Provider are only limited by their imagination. However, they can be easily pushed out of their boxes during market volatility, leading to Impermanent Loss and also requiring a more aggressive 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 a better fit for users than Trader Joe's Liquidity book model. But in terms of Liquidity efficiency, the Liquidity book model surpasses the V3 pool. The great flexibility afforded by price boxes makes Liquidity provisioning more attractive and profitable if done correctly.

The new level of capital efficiency introduced and fostered by both pools has had a positive impact on DeFi, freeing up capital for other productive uses. As both DEXs are incentivized to provide the best possible trading experience to attract users to their platforms, the continued development of Liquidity efficiency at the DeFi protocol level is imperative.