Original title: Uniswap V3’s Concentrated Liquidity vs. Trader Joe’s Liquidity Book
Author: Kofi J, CoinGecko
Compiled by: BlockTurbo
Comparison of Uniswap V3 and Trader Joe 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 providers (LPs) to choose custom price ranges, while Trader Joe’s uses discrete “price buckets” to allow LPs to define fixed price ranges for precise liquidity deployment.
The crypto market trades around the clock and never rests. The financial value of digital assets comes directly from user demand. Compared with the valuation of traditional assets such as 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 does not only exist within a single chain, but also includes a two-tier system of centralized and decentralized services. The state of DeFi is also constantly changing. New protocols naturally start out inefficient and become more efficient over time; however, in the "financial Lego" system of DeFi, these inefficiencies often spread to other areas.
As DeFi grows 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, filling gaps and profiting in the process.
Uniswap V3’s centralized liquidity model and Trader Joe’s liquidity book model provide great examples of protocol-level liquidity efficiency upgrades. In this article, liquidity efficiency will mean optimizing the use of currently available capital as much as possible.
What is liquidity and how to understand the AMM (Automated 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 capitalization before the 2017 bull run to today's market capitalization:
In 2017, Ethereum’s market capitalization was $27,681,279,352, with a daily trading volume of $456,818,455;
In 2023, the market capitalization of Ethereum is $251,586,840,870, and the daily trading volume is $9,272,832,786.
Ethereum’s market cap has grown by over 800% and its daily trading volume has grown by over 1,000%. These volumes are still spread across a variety of centralized and decentralized exchanges. But overall, it’s clear that the market is more able to absorb a $10 million Ethereum sell order now than it was in 2017 due to the increased liquidity depth.
Every trade requires 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 makers (MMs) to provide deep liquidity on both sides and make a profit by charging the so-called bid-ask spread.
A classic example of a market maker in the crypto space is Wintermute, who recently received 40 million ARB tokens for their market making activities. Market makers are still very critical because low liquidity can cause slippage, and if the execution price is different 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, which has become the blueprint for every subsequent decentralized exchange.
Instead of connecting two traders, traders buying assets use a liquidity pool as a counterparty, eliminating the need for an intermediary. The AMM model relies on incentivizing liquidity providers through transaction fees, while smart contracts rebalance 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 permissionless trading of digital assets possible.
Uniswap V3 centralized liquidity
Uniswap V3 was released in May 2021, introducing the concept of pooled liquidity. This model focuses on maximizing capital efficiency, resulting in better trade execution and increased fee income for liquidity providers.
The core innovation is to allow liquidity providers 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, this is the liquidity pool for ETH-USDT. The full price range is selected, reflecting the standard liquidity distribution in the V2 pool. The capital of liquidity providers 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 transactions occur within a narrow price range, most of this capital is not used, which is very inefficient.
In the example above, a custom price range has been selected for ETH-USDT. Liquidity providers will earn proportional trading fees based on their liquidity contribution within the predefined range ($1,706 and $2,303). In recent weeks, the majority of Ethereum trading has occurred within this range, and this custom range will allow liquidity providers to earn a similar amount of trading fees with far less capital than the V2 pool, or deploy the same amount of capital and earn more trading fees. In both cases, it will be better for liquidity providers thanks to the increased liquidity efficiency.
Uniswap V3’s concentrated liquidity pools are particularly beneficial for stablecoin pairs that trade within a narrow range, where in V2, up to 99.95% of the liquidity capital was never used.
Game theory comes into play in V3 pools, as users can choose where to allocate capital. Therefore, some providers will target unlikely but more profitable intervals, given the high share of liquidity provided within that interval, while others will focus on a narrower range. This ensures a reasonable distribution along the price curve.
In general, V3 pools allow for greater liquidity depth, which means lower slippage for traders and less capital for liquidity providers to earn the same trading fees. Second-order effects allow these capital savings to be put to productive use in other areas of DeFi. Pooled liquidity is a great example of how protocol-level liquidity efficiency upgrades can benefit all users.
Trader Joe's Liquidity Book
Many people know Trader Joe’s as the superstar DEX on Avalanche. However, Joe V2 has quickly become one of the most popular decentralized exchanges on Arbitrum, gaining traction following the ARB airdrop and massive trading volume. This growth has been fueled by Trader Joe’s new liquidity book model.
What are Bins in the Trader Joe's Liquidity Book Model?
Understanding Bins is crucial to understanding the liquidity book model. In the Trader Joe V2 pool, liquidity is deposited into different price bins. Each bin has a fixed price, and liquidity is placed into these different bins.
As long as the transaction remains within the scope of the box, users who trade in a box can get a fixed price, which means no slippage and extremely high price efficiency. All boxes are stacked together to provide deep liquidity, and liquidity providers 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 that significantly improves liquidity efficiency and provides users with more flexibility when providing liquidity. For example, they can place 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 for pooled liquidity, giving liquidity providers custom price ranges. Instead of being evenly distributed along the price curve, liquidity is deployed precisely, enabling greater transaction fee revenue. It also has the added advantage of handling greater volumes with less liquidity than a typical liquidity pool. In short, the liquidity book can serve a large number of traders with minimal liquidity. This model breaks away from the increasingly outdated model of relying on attracting large amounts of captive liquidity to provide efficient prices.
Thanks to the liquidity book model and the “price bins” it uses, traders can enjoy zero-slippage trading. Each bin is a single price point, and Trader Joe’s pools all of these bins into a single liquidity pool. “Active Bins” contain both tokens in a pair and determine the current market value of the assets. “Active Bins” are the only bins that earn trading fees, and trades made in this bin have no slippage. The introduction of bins even upgrades the centralized liquidity of Uniswap V3, as bin precision and liquidity are more concentrated at more narrowly defined price points.
When all the 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 the liquidity distribution, making trading more efficient. Different boxes provide liquidity within a specific price range, allowing for quick adaptation to market demand when needed. This dynamic structure helps reduce slippage and provides traders with better execution prices.
The image above shows the options for liquidity providers when using the Trader Joe V2 pool: Spot, Curve, Bid-Ask, and Wide.
Here is a simple example of how to take advantage of the Spot shape distribution:
In this ETH-USDC pool, liquidity providers can choose a range above the current market price and only provide ETH to the pool. As the ETH price rises and gradually passes through the boxes, users will gradually sell ETH and receive USDC. In the example above, the price range selected is relatively small, but users can choose any price target they want, which is an easy way to gradually sell a certain asset.
Vice versa; users can use the liquidity book model to unilaterally supply ETH below the current market price through a 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 provides liquidity providers with incredible freedom and flexibility in deploying liquidity. The fewer the number of boxes, the more concentrated the liquidity; therefore, the greater their share of revenue from all trades within this range. At the same time, liquidity providers face the greatest risk of impermanent loss if prices fall outside this range.
Liquidity providers can observe where other market participants are depositing liquidity on Trader Joe’s. The above chart shows the current liquidity distribution of ETH-USDC.
The above diagram shows several strategies outlined by Trader Joe, and users who wish to provide liquidity can choose the shape that best suits their goals. It is highly recommended that users start with test funds to gradually understand how the liquidity book model works before committing full funds.
In summary, the liquidity book model provides a new level of flexibility in liquidity provision, reduces slippage, and allows for more dynamic liquidity rebalancing, essentially opening up a new paradigm for traders and liquidity providers within DeFi.
Disadvantages
Impermanent loss
Impermanent loss is the biggest danger facing any liquidity provider. In simple terms, impermanent loss is the difference in value between deposited assets and withdrawn assets. When asset prices move a lot, liquidity providers face losses but hope that transaction fees will make up for this. In many cases, it may be more profitable for investors to keep tokens in their wallets rather than provide liquidity.
In both models, liquidity providers face a greater risk of impermanent loss than traditional pools because liquidity is distributed over a narrower range. Impermanent loss occurs when asset prices fall outside a specified range; the narrower the range, the greater the chance of impermanent loss. But in exchange for this higher risk, liquidity providers have the opportunity to earn more transaction fees, a classic scenario where risk and reward rise in parallel.
One might think that because Trader Joe's liquidity book model allows for more concrete liquidity provision, liquidity providers would be exposed to the greatest potential for impermanent loss in these pools. However, Trader Joe's introduced a volatility accumulator that measures volatility by monitoring box changes. When volatility rises, the volatility accumulator automatically increases swap fees, helping protect liquidity providers from impermanent loss.
Complexity
Uniswap's V3 pool and TradeJoe's liquidity book model both enable more centralized liquidity provision, resulting in higher transaction fees for liquidity providers and better trade execution and lower slippage for traders. However, both are more complex than the liquidity provision that many crypto users are accustomed to. This additional complexity can lead to more serious errors for users, so it is important to try and test each model.
Specific to the liquidity book model, liquidity providers are limited only by their imagination. However, they can easily be pushed out of their boxes during market volatility, leading to impermanent loss and requiring a more active management style. However, the nuances and complexities involved form part of the rewards of liquidity provision in this new era.
Competition will drive growth and benefit DeFi
On the surface, Uniswap’s V3 pools are more user-friendly than Trader Joe’s liquidity book model. But in terms of liquidity efficiency, the liquidity book model surpasses the V3 pools. If done correctly, the great flexibility provided by price boxes makes liquidity provision more attractive and profitable.
The new level of capital efficiency introduced and fostered by both pools has a positive impact on DeFi, freeing up capital for other productive uses. As both DEXs are incentivized to provide the best trading experience in order to attract users to their platforms, continued development of liquidity efficiency at the DeFi protocol level is imperative.
