Uniswap V3 explained

To better understand the innovations Uniswap V3 brings, let’s first look at the imperfections of Uniswap V2.

Uniswap V2 is a general exchange that implements one AMM algorithm. However, not all trading pairs are equal. Pairs can be grouped by price volatility:

  1. Tokens with medium and high price volatility. This group includes most tokens since most tokens don’t have their prices pegged to something and are subject to market fluctuations.

  2. Tokens with low volatility. This group includes pegged tokens, mainly stablecoins: USDC/USDT, USDC/DAI, USDT/DAI, etc. Also: ETH/stETH, ETH/rETH (variants of wrapped ETH).

These groups require different, let’s call them, pool configurations. The main difference is that pegged tokens require high liquidity to reduce the demand effect on big trades. The prices of USDC and USDT must stay close to 1, no matter how big the number of tokens we want to buy and sell. Since Uniswap V2’s general AMM algorithm is not very well suited for stablecoin trading, alternative AMMs (mainly Curve) were more popular for stablecoin trading.

What caused this problem is that liquidity in Uniswap V2 pools is distributed infinitely–pool liquidity allows trades at any price, from 0 to infinity:

This might not seem like a bad thing, but this makes capital inefficient. Historical prices of an asset stay within some defined range, whether it’s narrow or wide. For example, the historical price range of ETH is from $0.75 to $4,800 (according to CoinMarketCap). Today (June 2022, 1 ETH costs $1,800), no one would buy 1 ether at $5000, so it makes no sense to provide liquidity at this price. Thus, it doesn’t really make sense to provide liquidity in a price range that’s far away from the current price or that will never be reached.

However, we all believe in ETH reaching $10,000 one day.

Concentrated Liquidity #

Uniswap V3 introduces concentrated liquidity: liquidity providers can now choose the price range they want to provide liquidity. This improves capital efficiency by allowing to put more liquidity into a narrow price range, which makes Uniswap more diverse: it can now have pools configured for pairs with different volatility. This is how V3 improves V2.

In a nutshell, a Uniswap V3 pair is many small Uniswap V2 pairs. The main difference between V2 and V3 is that, in V3, there are many price ranges in one pair. And each of these shorter price ranges has finite reserves. The entire price range from 0 to infinite is split into shorter price ranges, with each of them having its own amount of liquidity. But, what’s crucial is that within that shorter price range, it works exactly as Uniswap V2. This is why I say that a V3 pair is many small V2 pairs.

Now, let’s try to visualize it. What we’re saying is that we don’t want the curve to be infinite. We cut it at points aa and bb and say that these are the boundaries of the curve. Moreover, we shift the curve so the boundaries lay on the axes. This is what we get:

It looks lonely, doesn’t it? This is why there are many price ranges in Uniswap V3–so they don’t feel lonely 🙂

As we saw in the previous chapter, buying or selling tokens moves the price along the curve. A price range limits the movement of the price. When the price moves to either of the points, the pool becomes depleted: one of the token reserves will be 0, and buying this token won’t be possible.

On the chart above, let’s assume that the start price is at the middle of the curve. To get to point aa, we need to buy all available yy and maximize xx in the range; to get to point bb, we need to buy all available xx and maximize yy in the range. At these points, there’s only one token in the range!

Fun fact: this allows to use Uniswap V3 price ranges as limit-orders!

What happens when the current price range gets depleted during a trade? The price slips into the next price range. If the next price range doesn’t exist, the trade ends up fulfilled partially-we’ll see how this works later in the book.

This is how liquidity is spread in the USDC/ETH pool in production:

You can see that there’s a lot of liquidity around the current price but the further away from it the less liquidity there is–this is because liquidity providers strive to have higher efficiency of their capital. Also, the whole range is not infinite, it’s an upper boundary shown in the image.

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