In the past few months, there has been a lot of discussion in the Uniswap Governance Forum about activating the “fee switch”, a piece of code that would allocate a portion of the LP fee directly to UNI governance token holders. It has existed since Uniswap V2 launched in early 2020, but so far it hasn’t been executed. Now, with Uniswap V3 out and an ATH in trading volume, UNI holders understandably want a piece of the cake, but currently there is no way for them to receive a share of the increased revenue.
On the other side, there are the Liquidity Providers that take the risk of Impermanent Loss (IL) and already have to live with small yields in exchange for putting up their funds. If these yields decrease even further, there will be a point where the LPs will not be able to turn a profit anymore. They would be forced to move their liquidity elsewhere, and it would become a death spiral for the protocol. One could argue that Uniswap has a lot of brand value as the number one DeFi protocol, but it is up for debate if MEV bots would follow the same rationale or go to the competition instead.
A currently ongoing Consensus check by Uniswap governance forum users Leighton and Guillaume Lambert proposed a 1/10 (10%) setting on the fee value for three pairs on Uniswap V3, which allows for variable fees on each pool: DAI-ETH-0.05%, ETH-USDT-0.3% and USDC-ETH-1%. These three pairs are initially meant to test the fee switch and provide the necessary data in order to implement it for the rest of the protocol. As can be seen on the Uniswap stats page, these pools are relatively high volume.
At the time of writing, there is a clear 3M to 46 UNI vote on implementing the fee switch on these pairs and allocating 10% of the LP fee to the treasury. The accrued value from this will remain in the protocol until the governance agrees on the best use for these funds. Apart from incentivising governance token holders, they could be used for funding public goods, building protocol owned liquidity (POL), or giving out grants to developers in the UNI ecosystem. No matter the outcome of the proposal, it is clear that this will set a precedent for similar protocols in this space and consequently it should be closely observed.
An alternative solution
Because of the impact of this vote and its significance for DeFi, we have thought about a potential alternative solution to the fee switch problem, one that is rewarding Utility and allows Uniswap to incentivise governance token holders without diluting the profits of Liquidity Providers. We think that this could set precedent for other AMMs and similar protocols in the future who run into similar problems with generating revenue. Enter Fluidity: We’re building a protocol that rewards users for using their cryptocurrency, so anything from sending transactions to performing swaps on a DEX, including Uniswap.
The way it works is by creating a “fluid” version of an underlying token, for example USDC and fUSDC. Users can provide liquidity to the protocol and receive the wrapped assets in return. Fluidity sources its yield by lending out the underlying principal on money markets, which then goes into the reward pool. Whenever someone performs a transaction with their fluid asset, they are eligible to receive a cash back reward that can range from a few dollars up to thousands of dollars worth, depending on how much TVL is in the protocol. Payouts happen after a few blocks of performing the transaction, so there would be no extended lockup period of funds. There are no extra or hidden fees.
Now, the part where this becomes interesting for Uniswap is that there is a 80–20 split between sender and receiver. That means if someone performs a swap and they are eligible for a 100 fUSDC reward, Uniswap would receive a 20 fUSDC share of that, which could go directly to the treasury and could be used to incentivise governance token holders. Most payouts will be lower, but we can take the probability distribution of fluid rewards and calculate the expected yield (the mean) for a single transaction/swap, which we will do in the following.
We start our calculations by giving a general overview of Fluidity payouts on Ethereum. Assuming a 3 USDC gas fee, 50,000 daily fluid transactions and a reward pool of 10 million USDC, we get the following numbers for a single fluid transaction:
The dot product of these two column vectors gives the expected value, which for this example is approximately $0.55/tx. Since the receiver gets a 20% share of the reward, the Uniswap treasury would earn around 11 cents for every fluid transaction. For Uniswap V3 on Ethereum, we can assume around 200k daily transactions. If we say that 5% of those transactions include a fluid asset, we can calculate the mean daily revenue for governance token holders to be $1,100, or around $400,000 per year. That amount is similar to payouts from the fee switch for pools with low LP fees. As an example, DAI-ETH-0.05% would earn the treasury around $136 daily (We took the volume of the last 7 days, which at the time of writing was around $19M).
To explore different scenarios, we can make a graph of the annual mean Uniswap treasury earnings based on the number of fluid transactions on Uniswap and for different revenue splits (they can be set by governance). Note that we calculate this with the expected value, so the revenue would be much greater for large payouts.
In the graph above we can see that if 10% of all transactions on Uniswap would be done with a fluid asset in it and 30% of the payout goes to the receiver, the treasury would receive an annual revenue of around $1,000,000, or $2740 per day.
We can do the same calculation for the current largest trading pair on Uniswap V3. According to this Dune query, the current largest pair by volume is the WETH/USDC pair, with a 7 day volume of $4B and 62,000 trades. If Fluidity would introduce a WETH/fUSDC pair and capture only 10% of the current volume, we can estimate the daily revenue to be around $1000.
In accordance with our calculations, we think it would be worth to explore a hybrid system, one that uses both fluid assets and the fee switch to find the most efficient pools where LP fees can be diluted and others where the fee switch can be turned off and instead be replaced through the revenue of fluid assets if the provision of liquidity would otherwise become unprofitable.
Conclusion
To conclude this thought experiment, we think that Fluidity could be a potential alternative solution that can work alongside the fee switch, to get the best of both worlds. For pools with relatively high LP fees, the fee switch can be activated to generate revenue for the treasury. For pools with low LP fees where liquidity would otherwise flee due to unprofitability, Fluid assets could be used to replace the fee switch revenue from these pools, so that the liquidity would remain in the pools.
We hope that this post encourages discussion to find more alternative and innovative ways to solve this problem.
To learn more about Fluidity, you can read our docs and the whitepaper. If you have any questions, be sure to contact us on our socials:
https://t.me/fluiditymoney
https://discord.gg/w9DVhGDR
https://twitter.com/fluiditymoney
