Liquidity providing in Uniswap v3 (1)
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Some remarks on being LP in new Uniswap
While there’s a lot of talk about new Uniswap „concentrated liquidity” and „capital efficiency” it brings, there’s no gain without pain. In this article I’ll present some observations and insights based on my recent research of Uniswap v3, including some backtest. I do not intent to write a comprehensive guide, but rather to quickly share some info that I think is valuable for LPs. Some things are very basic, some perhaps are not.
If you want to add the same amount (or rather value) of both token0/token1 to the pool (like in v2), you have to create a range that is symmetrical around current price. But you have to think in percents, not values! So if price is 150, symmetrical range is 75…300 not 0…300. Such range allows the price go up or down 2x. Just divide and multiple current price by the same amount (2 in this case).
Fee boost is my term for the multiplier applied to fees in some range. You can find interactive calculator for boost in blog post introducing v3.
The formula for “boost” is simple: 1 / (1 — (bottom / top) ^(1 / 4)). As you can see it depends only on bottom/top ratio.
How does this change with liquidity range getting wider? Some values are shown below, we start with ratio 1.05 and then make range 2x wider each time)
Ratio: 1.05, boost: 82.48x
Ratio: 2.1, boost: 5.91x
Ratio: 4.2, boost: 3.32x
Ratio: 8.4, boost: 2.42x
Ratio: 16.8, boost: 1.98x
Ratio: 33.6, boost: 1.71x
Ratio: 67.2, boost: 1.54x
Ratio: 134.4, boost: 1.42x
Ratio: 268.8, boost: 1.33x
Ratio: 537.6, boost: 1.26x
Ratio: 1075.2, boost: 1.21x
Ratio: 2150.4, boost: 1.17x
Ratio: 4300.8, boost: 1.14x
As you can see boost goes to 1x which is equivalent of Uniswap v2 fees with widening range.
You may think that Uniswap v3 is easy money. Just select some very tight range and you’ll get much more fees than previously.
Not so fast. There are multiple factors that affect your profits. I’ll cover some of it.
You’re not the only fish/whale in the pool
You’re not only one who will try to trade in some narrow range. So now everybody is adding liquidity to this range and you have to share your profits with many other LPs.
The good news is that perhaps it will be (to some extend) counterbalanced by more volume, particularly arbitrage volume. Arbitrageurs try to close the gap between Uniswap price and some other exchange price. If liquidity is concentrated in some range, they can do bigger trades (as trades now are less affecting the price on Uniswap), so the volume will be bigger.
Also retail traders (who just want to buy/sell some token) will be more inclined to use Uniswap if — thanks to liquidity concentration—they get better price on Uniswap than some other exchange. This also may lead to bigger volume but keep in mind that number of people who want to trade some token at any given time is limited, no matter how good the price is.
When you choose some narrow range to provide liquidity, you risk that some of the trades will fall outside this range. For my tests I use “volume capture” a as a term to describe it. Eg. 50% volume capture means that 50% of whole volume during some time was within the range and generated fees. It’s quite obvious that narrow ranges capture less volume. How much less? It depends on volatility and it cannot be predicted, but can be tested on historical data.
When v3 was introduced, Uniswap Team Members talk a lot about how capital efficient it will be and how LP profits can be higher by providing liquidity in range. There was much less talk about the fact that using some narrow range increases impermanent loss by a lot.
Let’s do a test. We’ll start with narrow range of 1.05 (eg. 100 / 105). Liquidity will be provided in the middle of the range (geometric mean, see above). Then, we’ll check how much we can withdraw from the pool if the price changes by 10%.
This may not seem much, but the question is: will your “narrow range” (let’s say you use 1.05 range) generate 4.18% of it worth in fees to cover this?
Is Uniswap v3 only for whales who can afford the gas needed to move liquidity positions very often? Find out in part 2 of this series.