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Overview of Uniswap (UNI)
is an open-source decentralized exchange and automated liquidity protocol built on . Uniswap allows users to create liquidity pools tokens to be launched and traded without any listing fees. It enables on-chain, trustless token swaps executed from smart contracts for small fees.
Uniswap executes its digital exchange under a constant product market maker, which is a type of model of an automated market maker (AMM). Inspired by Ethereum co-founder Vitalik Buterin and created by Haden Adams, Uniswap uses an AMM construction built from smart contracts, which allows anyone to create liquidity pools for any Ethereum token and to do so much faster than centralized exchanges. UNI is the governance token of the Uniswap ecosystem.
Anyone can pay a fee and provide liquidity to a pool that is then distributed to providers with respect to the amount of the provider’s pool share. Stakers provide a deposit of two tokens, either ETH and an ERC-20 token or two ERC-20 tokens, in return for interest from the principal. Stakers also commonly use other DeFi platforms, like , to put down the principle, incur interest, then take out flash loans to use as principle to enter a liquidity pool on Uniswap or other DeFi platforms to accumulate risky, high-volume profits.
Fee Switch
As of Q3 2022, 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 at any time. 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.
Trades on Uniswap V2 come with a 0.3% swap fee or 30 basis points (bp). In Uniswap V3, liquidity providers are given more control as they can set the swap fees for individual pools they are a part of. This could be 1bp, 5bp, 30bp, or 100 bp. With this in mind, both V2 and V3 also have a dormant “fee switch” that can be turned on via governance voting as described above. This is the only way in which UNI token holders can receive a share of the swap fees from pools.
The fee switch mechanic presents UNI holders with more than just a decision on swap fee allocation. Ultimately, the fee switch presents the Uniswap community with an opportunity to retain a portion of the revenue being given to liquidity providers and the best way in which to utilize that new revenue stream.
Within governance discussions, community members have pointed out that the fee switch does not necessarily have to only mean that UNI holders gain rewards. Retained funds can be used in many different ways, including:
- Ecosystem Funding
- Treasury Building
- Grant Funding
Uniswap routinely generates some of the highest amount of revenue in the crypto ecosystem, but without the fee switch, the protocol is technically generating no revenue and no profit. Introducing the fee switch ensures that the Uniswap protocol effectively monetizes decentralized swaps.
Proposal / Voting Process
Uniswap governance operates in a three-step process. There is an initial yes-no vote that requires 25,000 UNI to execute. Assuming the initial vote is passed, there is a secondary UNI yes-no vote that requires 50,000 UNI to execute. If proposals are able to pass both vote barriers, the final step requires a wallet to hold 2.5 million UNI tokens to officially submit a proposal.
initial vote following a discussion around the fee switch mechanism, voters overwhelmingly supported activating the fee switch at a balance of 3.5 million UNI to only 54 UNI voting no.
This vote was only a sentiment check to determine the opinion of the UNI community on the matter. This sentiment check was also in relation to V3 for three pools. Notably, these are the trading pools on Uniswap with the greatest volume. This particular proposal did suggest the lowest end of the possible fee spectrum at only a 10% cut from LP fees.
The three pools that would implement the fee switch are the following:
- ETH-USDC (1%)
- ETH-USDT (0.3%)
- ETH-DAI (0.05%)
This is only a temporary activation of the fee switch. It is stated in the proposal that it will be live for 120 days with all retained fees going directly to the Uniswap DAO treasury. This circles back around to the community discussions as there are still future decisions to be made, including whether to continue the fee switch long-term and exactly how to utilize the accrued revenue in the Uniswap DAO.
secondary consensus check was also held and resulted, once again, in overwhelming support for activating the fee switch pilot at 19 million UNI for yes and only 418 UNI for no. This proposal offered modest alterations to the first proposal, suggesting that the three named pools utilize different fee-tiers to determine the effect of the mechanism over a period of time. This would provide far more data and provide the UNI community with more valuable information.
Pros/Cons of the Fee Switch
The following represents an analysis of the pros and cons of the fee switch:
Governance is inherently limited in scope as there are only so many parameters in which it can be used to make changes to the core Uniswap protocol. Additionally, outside of governance, the UNI token has little to no revenue opportunities. This is why the fee switch is immensely important, as one of the other key utilities of the UNI token is governance power over the treasury itself.
The treasury for Uniswap holds 291,708,000 UNI tokens that are valued at $1.8 billion as of Q3 2022. This does not include another $1.3 billion that is illiquid and invested. In total, Uniswap treasury holds an estimated $3.1 billion. This places Uniswap as by far the richest treasury amongst other DAO. Below is a chart showing the treasury value of DAOs within web3.
This is a substantial amount of value, and with the fee switch, that value that has been accruing within the Uniswap treasury can be strategically reinvested back into the stakeholders of the Uniswap ecosystem. The ability for UNI holders to implement this is extremely important as the UNI token itself gains utility, and the Uniswap ecosystem can expand and improve its own value capture within the crypto economy.
Improving the utility and tokenomics of the UNI token can also help to attract more holders, increasing the number of stakeholders within the ecosystem. This, in turn, also brings in more value in terms of token investment.
The trade-off for sending 10-25% of protocol fees to the Uniswap treasury is that equivalent value is taken away from liquidity providers (LPs). With a reduction in fees, it may make liquidity pools on Uniswap less competitive in attracting new LPs. This is how Uniswap has grown its protocol over time, unfortunately at the expense of overall UNI token growth without the fee switch mechanism activated.
Taking away protocol fees, especially a significant amount raises the risk exposure of liquidity providers to impermanent loss. Due to the nature of AMMs, impermanent loss may occur due to the ratios of tokens changing within a pool, leading to fewer gains for LPs than what would be acquired if assets were not distributed to a liquidity pool. To offset this risk, swap fees are given to LPs, lowering risk exposure which ultimately incentives more LPs to participate.
Historically, LPs typically lose value to impermanent loss when depositing liquidity versus just holding liquid assets outright. So, a 10% reduction in fees could have serious implications on the competitiveness of Uniswap versus other competitors such as Curve or SushiSwap. In essence, higher competition could result in a liquidity crisis on Uniswap as LPs choose to leave UNI-based pools in favor of competitors.
Uniswap is a leading project within DeFi and the broader web3 space. As the largest DEX, the mechanisms and economic policies that the protocol utilizes will have lasting effects on the rest of the space. Thus, the fee switch is a very important issue as it establishes a precedent amongst DEXs.
Above all, the UNI fee switch proposal raises both significant pros and cons. The ideal scenario for the protocol would be a minimal impact on the protocol’s overall growth, with LPs seeing margins stay healthy. This would ensure that Uniswap stays desirable amongst competitors. This provides a huge boost for UNI token holders as well. With the Uniswap treasury accruing fees, the treasury now has a legitimate value extraction mechanism to create a revenue stream for UNI holders. This provides a major boost to the utility of the UNI token itself and ultimately helps all stakeholders of the ecosystem.
It is unknown as of Q3 2022 as to what effect a fee switch activation would have on the Uniswap ecosystem. What can be identified are the risks associated with such a proposal, regardless of the improved incentives to the UNI token. Liquidity is the most important aspect of Uniswap, and so incentivizing the growth of liquidity is essential to continually attracting users, generating fees, and extracting value.
