Uniswap recently unveiled a fresh transaction fee of 0.15% on its platform. However, unlike traditional expectations, these fees aren't remitted to the tokenholders. Instead, the fees are channeled directly to Uniswap Labs, the operational backbone of the Uniswap protocol. In practice, for every $100 transaction, Uniswap Labs will receive 15 cents. It's worth noting that this fee is reserved for a select group of tokens, such as ETH, USDC, WETH, USDT, DAI, and a handful of others. Transactions involving the mere swap of one stablecoin for another or conversions from ETH to WETH will remain exempt from this charge.
Post the announcement, there was a palpable shift in the market dynamics. But to comprehend the gravity of this move, a historical lens is needed.
A Look Back on Uniswap's History
Uniswap V1
Uniswap V1 paved the way for on-chain token swaps and liquidity pools to provide participants interest for giving liquidity. On V1 there is one exchange contract per ERC-20 token created by anyone using the Uniswap factory contract. The factory serves as a public registry and is used to search tokens and exchange addresses added to the platform. Token exchange rates are calculated using a constant product formula, which is a mechanism to keep a token’s value balanced compared to the token pair staked. The original token pairs were DAI to ETH or DAI to USDC, and each pair provided separate pools to earn a share of a 0.3% fee whenever a transaction was or is made. This share was or is based on the ratio of their pooled tokens relative to the whole pool supply. While the ETH-ERC-20 reserve ratio is always shifting, fees make sure that the total combined reserve size increases with every trade.
Uniswap V1 allows anyone to become a liquidity provider on an exchange and contribute to its reserves. After depositing an equivalent value of both ETH and the ERC-20 token, liquidity is pooled across all providers, and an internal “pool token” is used to track each provider’s share. These pool tokens are minted when liquidity is deposited into the platform and can be burned when a withdrawal occurs. Guaranteed price differences can be taken advantage of, and opportunities from these price fluctuations should push a steady flow of transactions through the system to increase the amount of fee revenue.
Only one exchange per token can be registered to the factory to incentivize pool participants into a single pool. However, Uniswap has built-in support for ERC-20-to-ERC-20 trades using the public pools from the factory on one side of the transaction and custom, user-specified pools on the other. Custom pools could have fund managers, use alternate pricing mechanisms, remove liquidity provider fees, or potentially even integrate complex three-dimensional FOMO (fear of missing out)-based ponzi schemes. They simply need to implement the Uniswap interface and accept ETH as an intermediary asset. Custom pools do not have the same safety properties as public pools. Unfortunately, Uniswap V1 cannot be used safely as a price oracle because the price can move significantly quickly.
Uniswap V2
Where V1 was the proof-of-concept, Uniswap V2 added many new features and improvements to this liquidity protocol on the Ethereum blockchain that enable ERC-20 token swaps created from smart contracts. V2 introduced new functionality that enables highly decentralized and manipulation-resistant on-chain price feeds. Uniswap does this by measuring prices when they are expensive to manipulate and accumulating historical data. This allows external smart contracts to create gas-efficient, time-weighted averages of Uniswap prices across any time interval.
These price feeds are also essential for other DeFi like derivatives, lending, margin trading, and prediction markets. Uniswap V2 offers several improvements for price feeds built on it. First, every pair measures the market price at the beginning of each block before any trades take place. This price is difficult to manage because it is set by the last transaction in a previous block. To set the measured price to one that is out of sync with the global market price, an attacker must make a bad trade at the end of a previous block, typically with no guarantee that they will be able to arbitrage it back in the next block. Attackers will lose money to arbitrageurs unless they can “selfishly” mine two blocks in a row. This type of attack presents several challenges and has not been observed to date.
If significant value settles based on the price resulting from this mechanism, then the profit of an attack likely can outweigh the loss.
Uniswap V3
Where Uniswap V1 was launched in November 2018 as a proof of concept for AMMs and V2 set the stage for growth. V3 aimed to target a Ethereum mainnet and was launched on May 5, 2021. The upgrade executed a deployment on Optimism (an Ethereum layer that addresses scalability) in order to introduce concentrated liquidity and multiple fee tiers.
Concentrated liquidity gives individual liquidity pools control over what price ranges their capital is distributed to. This upgrade allows individual positions to be merged together into a single pool, forming one combined curve for users to trade against. Multiple fee tiers allow liquidity pools to be compensated for taking on varying degrees of risk. Liquidity pools will provide up to 4000x capital efficiency relative to Uniswap V2, allowing higher earnings.
The capital efficiency upgrades also allow low slippage trade execution, increase liquidity pools’ exposure to more assets, and reduce downside risk. In V3 liquidity pools, the user can sell one asset for another by adding liquidity to a price range above or below the market price. In doing so, the liquidity pool construct will be customized to individualized price curves that reflect the user’s profit.
In May 2021, a community-driven effort forced the Uniswap protocol to hold a community vote over whether V3 should be deployed utilizing Ethereum layer 2 scaling solution Arbitrum. Two days after the vote began, the poll passed with 41.72 million UNI (-13.59%) in favor and only 309.34 UNI against.
Arbitrum went live for developers in June 2021, giving them access to Arbitrum’s increased transaction throughput than Ethereum and lower gas fees.
In July 2021, Uniswap V3 launched on Optimism (in alpha) with six assets after passing a Uniswap governance vote. Optimism is an Ethereum layer 2 scaling solution that makes Uniswap trades near-instant and reduces fees ~90%. It is a monumental step for Uniswap and Ethereum towards a years-long search for scaling solutions.
UNI Token Utility
As of Q4 2023, holding UNI only gives users the right to participate in protocol governance. However, UNI token holders can vote to turn on a "fee switch" on a pool-by-pool basis. If the vote passes for that individual pool, 10-25% of the liquidity provider's fees will go to the protocol. These fees can then, theoretically, be redirected to UNI holders via buybacks and burns. While these mechanisms would turn UNI into a productive asset, they would also reduce revenue for liquidity providers, meaning that these cash flows may come at the cost of hampering the protocol’s growth.
Equity holders vs. Token holders: The Core Dilemma
The schism between equity holders and token holders isn't just about transaction fees. It's rooted in a deeper conundrum:
Value Distribution: With a venture having a treasury, market cap, equity value, and myriad legal obligations, determining value distribution becomes complex.
Treasury Rights: The ambiguity surrounding the ownership of treasuries often sparks disputes. The rights to both the funds and their allocation remain contentious.
Presumed Rights: Tokenholders may assume rights, such as financial transparency or decision-making influence, which might not be enshrined in official documentation.
Legal Quandaries: Tokens can sidestep traditional legal structures, but this can lead to ambiguities regarding entitlements in the face of conflicts.
Principal-Agent Dilemma: The chasm in knowledge and transparency between token holders (principals) and developers or organizations (agents) magnifies the age-old principal-agent problem.
Strategic Misalignment: Equityholders could emphasize long-term viability, whereas token holders might prioritize immediate token value appreciation.
Reliance on Social Contracts: Trust-based "social contracts" might be foundational, but they could falter when juxtaposed with the binding nature of conventional legal contracts.
Risks of Devaluation: The nefarious act of "rugging" underscores the potential peril token holders face, wherein they are left with devalued tokens due to the protocol's malintent.
At a cursory glance, Uniswap Labs, the Uniswap protocol, and the UNI token may seem intertwined. But a deeper dive reveals myriad conflicting objectives and interests. This recent fee introduction is but a microcosm of the broader challenges and negotiations at play in the decentralized finance space.
