Uniswap V3 and Farms Are Not Compatible

Uni V3 Launch

The following is my opinion on what Uniswap V3 has the potential to do to Defi farming, should it be broadly adopted. It is my observation that V3 is not fundamentally compatible with current farms for a variety of reasons I will get into, and that in a way, V2s linear curve has essentially created the much of the DeFi bubble we are in now (Check my profile for more or my twitter @MrGondee). The below discussion is somewhat technical and really targeted at other fund managers and sophisticated market participants. Additionally it may serve as guidance for DeFi projects on “Should we migrate to V3”.

X*Y=K AMMs (Uni V2) vs Order book based (Uni V3)

First lets discuss the differences between V2 and V3. At the most basic level, V3 LPs get the ability to select a range or price band within which they will make trades. If the price falls below the price band the LP will have 100% exposure to the falling asset (all of their bids will have been hit with no corresponding asks). Conversely if the price goes on a large upswing through the top of the band, all the LP’s asks will be triggered and you will then hold 100% the non appreciating side of the trade. This means the LP will need to adjust their positions to avoid consistently taking the wrong side of the market. Exactly the same as a traditional order book market maker does. In V2 the user has a 50/50 balance of both assets, with liquidity linearly spread end to end on the price curve, no adjustment was possible or needed. This allows for standardized LP tokens and a easy to use liquidity providing experience. Really the only advantage sophisticated market participants have was to remove liquidity selectively during certain volatility events to avoid IL.

V2 and Farming

While I have not seen concrete data on this, I would assume based on trading experience that the vast majority of V2 liquidity, and AMMs in general, is provided for the purpose of “farming”. This can pretty easily be assumed because on its own, V2 was not a profitable market making algorithm for most pairs. Two low correlation coins destroys the LPs with Impermanent loss. There is one subtle property of AMM’s in the X*Y=K format that has enabled this proliferation of projects whom exist either just to farm, or are a carbon copy of a real project (Read my thoughts here).

With the price curve being distributed linearly in V2 AMM, it also means that unlike and order book based market, the liquidity cannot move around to price future risks into the liquidity curves. This allows us as farmers to exploit LP’s, and perpetually sell rewards into these linear curves with minimal price impact. V2 creates a buyer at all prices that is naive of the future. Following my guide to the mechanics of 2Pool farms guide (link on profile), this allows projects to rapidly gain large market caps and then sustain them relatively well despite large issuance/dumping. This fact has been the “killer feature” discovered by the market during this bull cycle, similar to how ICO’s were in 2017.

V3 Game Theory and MEV

V3 market depth chart

Order book markets have market makers (Same thing as LP basically) providing liquidity to the order book in accordance with how they believe future price action will be. They typically make money on the spread between the bid and ask + potentially a rebate. In traditional markets High Frequency Market Makers pay for the right to observe orderflow and execute against it before it actually becomes a market order. On chain trading with an order book based exchange like V3 is very similar to this in that sophisticated firms can observe the order in the mempool and then act. For example:

The market is about to begin pumping, CEX exchanges start the move and arbitrage bots put their orders into the mempool for execution. Market Makers see that and through MEV mechanisms, like flash bots or just over gassing on chain, remove their liquidity to avoid getting filled yet. Orders consume some liquidity and push the price down. Now in the next block the MM decides that its time to start soaking order flow, jumps back in line at the new price level and begins to get their bids filled. Static participants have no liquidity in that air gap above the current price, so its wide open for active MM’s. After getting filled, new asks are placed in the air gap created by the sell off and on the rebound, its the active participant that gets the prioritized fill. Additionally, its the static participant that did the majority of the premature buying.

If you have spent any time creating market making trading software, you know that in the presence of other active participants, you cannot be static. I wont run through a ton of examples, but ask for more in the comments if you want. The arms race has begun with V3 and providing liquidity on non stable pairs is now the domain of the quants/sophisticated firms.

Putting it together: V3 and Farming

It is my opinion that most pool 2 farms should not migrate over their liquidity via some wrapper project or simple static price curve model. For the reasons I outlined above, static players will get crushed rather quickly, and increasingly so as market sophistication arms race gets going. Projects should not risk the passive liquidity players (ape money) with an order book. Sophisticated players will chop them to death and once they realize they are quickly loosing, either rewards will need to be increased or they will leave. And here lays the second problem. With passive liquidity taking a beating, sophisticated liquidity will have to be the dominant player. They will place orders knowing of the tokenomics of the project. If that means high emissions to sustain high APYs, then they will be forced to widen the spread and pull orders back. Farm participants will not have the indiscriminate buyer at all prices any longer. This would cause much less selling to have a higher impact on the projects suggested APY figure via a lower coin price, leading to a relative death spiral of market cap/TVL/liquidity.

Farm owners need to ensure they have indiscriminate buyers at all times, and the V2 model, while bad for the LP’s, allows the party to continue. I find it somewhat disturbing that sophisticated market players are not talking about the bubble that X*Y=K AMM’s have created in the defi space. Happy to discuss further.

CEO — OnChain Alpha