The pools are open! The Uniswap V3 staking smart contract is now up and running. With it, the decentralized exchange (DEX), which is now sitting comfortably at the top of the CoinMarketCap ranking, experiments with an innovative gamified approach to rewarding users for contributing coins into liquidity pools. Uniswap first announced the new feature in the whitepaper for its V3 release back in May, and in some ways, it reinvents the entire strategic calculus for liquidity providers (LPs). Is this the best solution for crypto’s long-running liquidity woes?
To work as a regular market maker, a decentralized exchange needs pools of various tokens that users can tap into when exchanging or buying crypto. These pools are made by allowing DEX users to stake their coin pairs of choice into a smart contract, locking it for the exchange to use. The user cannot make transactions with the staked coins unless they choose to withdraw them. They do, however, earn yields from transaction fees accumulated by the pools they have contributed to based on their relative share there.
From an LP’s perspective, this process, known as liquidity mining, comes down to the following risk versus reward assessment. The reward is the fees users pay for using the pool. The risk, though, is to see the total value of your stake reduced due to price swings and appropriate corrections of the number of tokens held in the liquidity pool. This is known as impermanent loss, since it can be offset by new price swings, but if the LP chooses to pull the stake out, it becomes permanent. So the main question for any prospective LP to consider is whether they ultimately win more by staking or HODLing.
So far, so good. Now, here is what’s new: With Uniswap V3, LPs stake their coins to only provide liquidity within a specified price range. Should the asset price hop outside this range, their stake is no longer considered active, and thus, no longer earns them yields.
Uniswap V3 and its concentrated liquidity add a whole new level of strategic depth to the process by making LPs consider another question: What price range are they going for? Staking 10 ETH into the right range brings the same yield as staking 100 ETH into the entire range from zero to infinity. By extension, if you are capable of staking 100 ETH, staking 10 ETH into the right range leaves you with 90 ETH to go around and invest elsewhere.
While novel, the Uniswap V3 approach to staking can be expected to reward professionals the most. It also makes staking inherently active as you have to keep moving your stake into new price ranges again and again to max out your earnings. This could, however, hypothetically scare off those unwilling to play this game as it brings more risk management into the picture, making the strategizing significantly more complicated.
To HODL or not to HODL?
As Uniswap experiments with gamified liquidity mining, the other approach shaping up is to incentivize staking by reducing its risks and protecting users against impermanent loss. Ideally, it is offset by the reward anyways, but things don’t always go as planned, and that’s why in 2020, Bancor implemented impermanent loss protection. Simply put, when LPs withdraw their coins from a Bancor pool under certain conditions, the exchange hands them a certain amount of BNT to cover their permanent loss. This was a big milestone for the DeFi community, as Bancor was the first automated market maker to introduce something like this. Its other breakthrough feature is single-sided exposure, which allows the user to only stake one token into a pool instead of a token pair, still covered by impermanent loss protection.
More recently, the THORChain liquidity protocol implemented impermanent loss protection as well, largely borrowing Bancor’s approach and covering losses with its RUNE token. Yearn.fi is also moving towards impermanent loss protection, as announced by its founder. This hints at what could be a larger trend among DEXes as they work to incentivize more users to join their liquidity pools.
Noble as they are, such initiatives have a major flaw as they technically work against backers of uprising DeFi projects. Here is what this means: Should a project’s native token take off like Dogecoin before May, on withdrawal, your impermanent loss will be offset in BNT or RUNE, while you would probably prefer the native token instead. At the same time, the possibility of drastic price swings prompts DEXes to keep limits on liquidity pools involving new tokens.
External impermanent loss protection could be the solution. DeFi could offer their own coins to cover the losses incurred by LPs, with the DEX’s own insurance kicking in once these reserves had been depleted. This would remove the risks the exchange is facing by leaving it up to its partner to deal with the insurance, thus enabling them to make the liquidity pool larger. It would also reward those investing into the DeFi project by paying them in the token they wanted in the first place. The approach is spearheaded by the DAPP Network, which recently approached Bancor with the proposal to provide external IL protection in what could potentially set the benchmark for similar initiatives in the future. Should this initiative take off, Bancor may want to consider a native implementation allowing DeFi projects to provide tokens for their respective impermanent loss protection pools without having to develop and deploy a smart contract for that.
As the nascent DeFi ecosystem evolves and matures, DEXes experiment with different strategies for incentivizing liquidity. The ones that prove to be effective will become the future benchmarks, and while it’s too early to call the winners, a solution that takes into account the needs of the highest number of stakeholders seems to be the optimal one.