This article is part 4 of my “Liquidity for All” series.
If you’ve made it this far, you must be an ace yield farmer or DeFi enthusiast. So without further ado, it’s my great honor to introduce…Uniswap v3 and the invention of “Non-Fungible Liquidity”!
Uniswap v3 Concentrated Liquidity
Uniswap prepared a friendly video explaining this upgrade, and I will use a screenshot from it to summarize.
The core concept of providing liquidity remains the same, but you can now set a price range between which you want your liquidity to be concentrated, or used for transactions. In Uniswap v2 this was abstracted from the user: liquidity was always distributed evenly between $0 and $Infinity for all token pairs, so most liquidity was never actually activated. Especially for stablecoins where the price varies little over 0.99 and 1.01, concentrating liquidity around $1 to activate the previously-unused 99.5% of the pool (highlighted in red on the diagram) seems only logical, but is a huge technological achievement that enables LP’s to ““provide liquidity with up to 4000x capital efficiency relative to Uniswap v2, earning higher returns on their capital”.
In order to specify price parameters for a liquidity position, we first need to be able to distinguish it from other providers’ positions. This is where NFTs come into play — not as certificates of authenticity for digital art, but rather to uniquely identify a liquidity position with attached instructions about what price range it should be concentrated within. Note the “Price range: In Range” indicator on the top image.
Non-Fungible Liquidity is not only a game changer for Decentralized Exchanges, but also for investors who are now responsible for managing their own liquidity price parameters. If I want, I can pool stablecoin pairs like USDC-MIM (“Magic Internet Money”, my favorite stablecoin) between $0.1–$0.8 and never have my liquidity used. This used to happen behind the scenes on Uniswap, and still does on most DEXs, so previously they just rewarded everyone equally. But now this liquidity position would not yield any rewards since it would never be ‘activated’. One may be better off leveraging preset liquidity positions offered by yield aggregators such as Harvest Finance with actively managed price ranges and additional rewards in other tokens.
To the best of my knowledge at the time of writing, Uniswap v3 is the only DEX that offers concentrated liquidity positions, but other DEXs are expected to follow suit due to the massive increase in capital efficiency.
Olympus DAO Bonding
If you recall in part 3 we briefly discussed “Ape” liquidity, where startups offer unsustainable incentives to attract early investors to become liquidity providers. If these rewards dry up, if the price rockets and LPs want to take profit, or if for any other reason the whimsical DeFi crowd-funders decide to withdraw their liquidity: an extremely promising project could suddenly collapse and seems like a liquidity risk or “rug pull”. This is a major hurdle for current DeFi startups — ensuring a reasonable constant supply liquidity without forcing investors to enter long-term staking contracts.
Olympus DAO is “a decentralized reserve currency protocol based on the OHM token. Each OHM token is backed by a basket of assets (e.g. DAI, FRAX) in the Olympus treasury, giving it an intrinsic value that it cannot fall below.” The team realized that short-term liquidity providers are not a permanent solution, and prioritized owning their liquidity. This is implemented in by “introducing unique economic and game-theoretic dynamics into the market through staking and bonding”.
I apologize for the excessive copy-pasting, but the Olympus docs are so good that there is little use in rephrasing: “Bonding is the process of trading an LP share to the protocol for OHM. The protocol quotes an amount of OHM and a vesting period for the trade. It is important to know: when you create your bond, you are giving up your LP share. The protocol compensates you with more OHM than you’d get on the market, but your exposure becomes entirely to OHM and no longer to OHM-DAI LP.”
In other words, Olympus ensures that its liquidity never drys up. They buy back LP from investors to stake in the treasury in exchange for OHM tokens. This ensures stable exchange rates and guaranteed liquidity for a predictable and long-term period. New projects such as Klima DAO have forked and repurposed this model towards different treasury assets, namely carbon offsets, and it will be interesting to see how this “liquidity treasury” model evolves in the future.
The innovations discussed in this article are extremely new: Uniswap v3 was announced on March 23, 2021, Olympus DAO’s OHM token was launched the next day, and there will probably be more developments before the end of the year that I will have to include here. Liquidity is a powerful and rapidly-evolving area of DeFi with acute interest from investors, developers, and community organizers alike.
And I bet it has caught the attention of numerous regulatory and tax bodies as well. In the 5th and final part of this series, we review tax implications and optimizations for yield farmers.
