How the coming concentrated liquidity boom will benefit DeFi – except maybe arbs

By Rohan Shama, Lead Analyst, DefiEdge

The expiry of the license that protected Uniswap V3’s code for two years promises to transform decentralized exchanges (DEXs), delivering big benefits for investors and making the entire system considerably more capital-efficient. 

Although it is not even two weeks old, the expiry has already fueled a rush to imitate the concentrated liquidity feature that made Uniswap V3 one of the most popular DEXs in the decentralized finance firmament, and we expect many more to come. 

The rush began with Pancake Swap, which launched its fork on Ethereum and Binance’s BNB chain just two days after the April 1st expiry. Rivals Sushiswap and ApeSwap followed within days. Uniswap, meanwhile, shows no sign of retreating from the battle: it plans to deploy V3 on BNB, where Pancake Swap is a dominant player. 

Concentrated liquidity and capital efficiency

So what is concentrated liquidity and why do we believe its widespread adoption heralds a new era for DeFi?

Before Uniswap V3, the pools of liquidity DEXs would draw upon to facilitate transactions were undifferentiated: in other words, liquidity was allocated across the entire range of prices a given token might reach. This meant that much of the volume would sit under- or unused and liquidity providers would only earn fees on part of the liquidity they deployed. 

Uniswap V3 came with a feature called range-bound concentrated liquidity. This gave liquidity providers the power to target liquidity they contributed to a pool specifically at price ranges where trades were most likely to happen. This helped them earn better returns – making liquidity provision a more attractive prospect – and released significant amounts of capital from bondage. 

The approaching liquidity surge in DeFi

With a host of DEXs now free to offer the same facility to liquidity providers, we see concentrated liquidity spreading throughout DeFi, changing the game for all. This will have far-reaching effects on the landscape and on investor behavior. 

One of the issues with undifferentiated liquidity is price slippage: the gap between the price at which a transaction can be completed and the prevailing market price for a given token. 

We believe that as liquidity gets more concentrated, the ecosystem will benefit from drastically reduced price slippage for large swaps. Reduced slippage will not only help everyday users but also benefit lending protocols when they have to liquidate under-water collateral positions during times of high market volatility. 

One segment of participants who will suffer, though, are arbitrageurs.  Arbitragers earn money by equilibrating prices across different DEXs and pocketing the difference. In other words, they make money from market inefficiencies. As price slippage lessens and DeFi becomes more efficient, the opportunities for arbitrage will also start drying up. 

By far the biggest improvement that will come from increased concentrated liquidity is in user education and investor confidence. As concentrated liquidity DEXs proliferate throughout the DeFi ecosystem, retail and institutional investors will be presented with ample evidence of the untapped potential these contracts hold. 

This broadened appeal will attract still more investors, including those who have opted for the seeming comfort of centralized exchanges in the past. This will in turn increase liquidity and make the whole system still more liquid and therefore more efficient. 

Further efficiency will come as the adoption of concentrated liquidity allows providers to take a more targeted approach to investment. Because they can earn higher returns, they will no longer need to lock up as much capital as they must in undifferentiated pools. Concentrated liquidity automated market makers (AMMs) can also support the same volume of trades with lower capital reserves than their predecessors.

Let’s look at the current Total Value Locked (TVL) in the four top DEXs that have launched or announced they plan to take advantage of the Uniswap V3 expiry (as per DeFi Llama): 

1. PancakeSwap: $2.4 billion
2. Sushiswap: $552 million
3. BiSwap: $236 million
4. ApeSwap: $50M TVL

Cumulatively, these DEXs currently account for more than $3 billion (1.67M ETH) of locked liquidity. 

When Uniswap V3 launched in 2021, V2’s TVL V2 dropped from 3.8 million ETH to 2.3 million ETH. And yet only 750k ETH of liquidity migrated to UniswapV3 pools. In other words, just half of the 1.5 million ETH that flooded out of V2’s pools found its way to V3. 

If the same scenario were to play out this time around, it would result in a drop in TVL supporting DEXs in the Ethereum ecosystem of nearly $2 billion and free up this capital to be deployed elsewhere. 

One other change that may result is an increase in the popularity of Layer 2 chains that promise faster transaction speeds and lower fees. This is because the rush of new liquidity will considerably amplify the volume and tempo of deal-making, so the cost of transactions – or “gas” – will become an increasingly important consideration for investors. 

One final note: competition among DEXs is almost certain to intensify as they seek to capitalize on what we believe will be a sea change in DeFi. 

Which of them will come out on top remains an open question. One thing seems clear, however – the ultimate beneficiary in this new era for DeFi will be the investor.