In-depth analysis of the innovation and disruption of Uniswap V4

Analysis of Uniswap V4's innovation and disruption.

Original author: Lian Zhu, Aperture Finance CEO

Japanese designer Kenya Hara once described his design philosophy as follows: “There are only two things we use in this world, a stick and a bowl.” “Bowl” refers to any vessel that carries other things, such as a bookshelf or refrigerator; while “stick” is a tool that acts on other things, such as a screwdriver or lever.

If Uniswap V3 is more like a bowl, carrying liquidity to empower DeFi, then V4 is more like a stick, promoting industry change through functionality and subverting the current state of DeFi. As a DeFi practitioner, based on the current information, it is not difficult to imagine that a storm is brewing, and V4 will inevitably cause a bloodbath half a year after its launch.

Looking back at the history of this “unicorn,” Uniswap V1 (first version) was born in November 2018 as the first decentralized exchange on Ethereum, providing exchanges between ERC-20 tokens and ETH. Other projects that started or borrowed from the same period include SushiSwap, 1inch, Curve Finance, Balancer, and Synthetix. Uniswap V2 (second version) was born in May 2020, further providing exchanges between ERC-20 tokens. With its liquidity empowerment, projects that emerged during the same period include Yearn.finance, AAVE, Compound, and Chainlink. Uniswap V3 (third version) was launched in May 2021, introducing centralized liquidity. Projects that became famous for providing position management include Visor Finance (later merged into Gamma) and Instadapp, among others.

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From V1 to V3, there were technological breakthroughs, but essentially they were in the same vein, and the project relied on Uniswap to build a huge ecosystem. However, from V3 to V4, technology is no longer a breakthrough from scratch, but a subversion of the market. The following is a brief analysis from the perspective of liquidity and product form.

Uniswap V3 integrates liquidity pools, which are relatively concentrated for a certain currency pair. The liquidity pools of Uni V3 are defined by two parameters, namely “currency pair” and fee rate. For example, for ETH-USDC, there are four liquidity pools in V3, corresponding to four levels of fees. These four pools provide liquidity for all trades between ETH and USDC. However, in Uniswap V4, this situation has changed. Its subversion and innovation lies in the fact that everyone can customize their own pools and implement various additional functions through “hooks.” So for the ETH-USDC currency pair, theoretically, there can be countless pools, such as market maker Zhang San providing an “ETH-USDC-Zhang San pool,” market maker Li Si providing an “ETH-USDC-Li Si pool.” The Zhang San pool has its own functions, and the Li Si pool has its own selling points. There can be countless pools to provide liquidity for trades between ETH and USDC, and the fragmentation of liquidity can be imagined.

Taking hotpot as an example, Uniswap V3’s liquidity pool is like a big pot where everyone shares the same flavor, without the need or ability to choose. But the pot is big enough and the water is deep enough. Here, the water represents liquidity. Uniswap V4 allows everyone to customize their own little pot, providing various special flavors to attract diners. The “flavors” here are analogous to the features added through hooks, such as on-chain limit orders and automatic reinvestment. There are many flavors, and everyone can choose their own. However, the more the pots are divided, the water remains the same, so some small pots may not have enough depth to cook the meat.

Uniswap V4 provides unprecedented openness, enabling a hundred flowers to bloom while opening a Pandora’s box, which may lead to consequences including:

1) The fragmentation of liquidity. From the perspective of the existing market, there is only so much liquidity, and the more pools there are, the less average liquidity there is. If one pool has more liquidity, another pool has less liquidity. In extreme cases, if liquidity is evenly distributed among countless small pools, a large transaction cannot be completed within one pool. Therefore, in an environment with multiple liquidity pools, the role of liquidity aggregators like 0x or 1inch will be doubly highlighted.

2) Reducing the difficulty of competitors entering the market. Some complex rebalancing functions (such as triggering rebalancing based on market conditions), if implemented on V3, need to be completed through off-chain infrastructure to perform real-time pricing and send transactions to the chain. Common methods include using Gelato services or building their own off-chain infrastructure (Aperture Finance adopts the latter approach). On Uni V4, with hooks, the project side can natively implement condition-triggered rebalancing functions without relying on third parties or building separately, greatly simplifying development and reducing operating costs.

3) Liquidity management projects or market makers may adopt more aggressive incentive measures to compete. The functions that can be added through hooks in Uniswap V4 are unlimited, including custom profit distribution or subsidies. If a bank provides foreign exchange services that not only allow users to exchange according to their ideal exchange rate, but also have no handling fees and even subsidies, then this bank is sure to be popular, and other banks will probably have to follow suit. The project side can choose to subsidize various costs, or even pay users to join their own pool. This will cause liquidity to be eroded and fragmented among project parties, and the degree of internal competition can be imagined.

4) The process of natural selection will be accelerated. Liquidity originally present in Uniswap V2 or V3 may gradually be withdrawn and transferred to V4. DeFi projects relying on V2 or V3 may struggle due to loss of liquidity, and competition for liquidity pools in V4 will continue to intensify (following the previous point), accelerating the downfall of some projects and ultimately leading to a monopoly situation.

5) A test of brand recognition. From a user experience perspective, the previous coin exchange experience involved simply selecting the coin and quantity, but after V4, users will also need to select the pool. It is not yet clear what the user experience will be like when selecting liquidity pools, but once users have to choose between similar pools, brand recognition becomes particularly important in addition to functionality and benefits. This poses a challenge for project teams on how to maintain their brand image and stand out from the competition.

With the storm approaching, DeFi-related projects need to plan ahead. There are still six months to go before Uniswap V4 is launched, whether it will be a success or a failure remains to be seen!

About the author: Lian Zhu, Web3 entrepreneur and translator. Co-founder and CEO of Aperture Finance. Former senior product manager at Amazon Kindle, Netflix, and AWS. EMBA from UC Berkeley Haas School of Business, and an MA in Interpretation from the Monterey Institute of International Studies. Member of the North American Writers Association and the American Translators Association (ATA), with translations including over thirty books such as “Rebirth” (by Stephen King) and the “Diary of a Wimpy Kid” series.

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