Opportunities brought by Uniswap V3 to governance token distribution along with liquidity mining

Jimmy Yin

izumi Labs

“If you are running a DeFi project and thinking about the strategy of governance token distribution and how to attract liquidity providers, you should look at Uniswap V3 for inspirations”

1. Introduction to Liquidity Mining and Token Distribution

In August 2020, the decentralized exchange Sushiswap started liquidity mining, and initially subsidized Uniswap LP(Liquidity Provider) token staked on Sushiswap, and then launched a liquidity migration subsidy program for Sushiwap LP. The liquidity mining mechanisms created by Compound and Sushiswap solves the problem of early liquidity provision and community expansion of the project, and has a great inspiration on the development of DeFi ecology.

After that, the token distribution along with liquidity mining becomes the standard configuration of DeFi projects. Following Sushiswap, there emerges lots of XXswap, whose token distribution along liquid mining is modified to focus on its own governance token liquidity. The pools or pairs including its own governance token will get significantly higher APY than others, so as to attract investors who do not even use the product. For instance, XXswap launched its XXT and provided huge token distribution incentives to the AMM pair XXT/USDT, thus providing liquidity and supporting the price of its token XXT. Though the mechanism is useful in the early stage to boom up the governance token price, it does not provide the required liquidity for real business and the prosperity lasts shortly.

With the collapse of the XXswap token price and the dispersal of the community, how to design the governance token distribution along with liquidity mining becomes the meaningful challenges for DeFi developers and communities.

It is widely adopted that the mechanism of governance token distribution along with liquidity mining contributes in three points for DeFi pojects:

  1. The first is the fair launch of tokens and community governance, thus to break the traditional disadvantages of ICO and IEO;
  2. The second is providing incentives and subsidies to accumulate users and liquidity in the early stage of the business liquidity mining, like above-mentioned Compound and Sushiswap, subsidizing users who provide liquidity for early lending and trading;
  3. The third is to provide liquidity and price support for the project’s own governance token. It helps form a positive expectation of community development and enhances the booming up process of token.

This research will focus on discussing the advantages and disadvantages of different strategies of governance token distribution along with liquidity mining, especially around the third purpose above, and propose useful models brought by Uniswap V3 to improve the process.

2. Economic analysis of the governance token distribution with liquidity mining in Uniswap V2

In CFMM, liquidity is distributed evenly on both sides of the current price. It can be understood equivalently that LP placed continuous pending orders along the price and when the price crosses the pending orders, buy (sell) orders turn to the opposite sell (buy) orders. Let’s take the pair of ETH/USDT as an example. Assuming that 1ETH=2500USDT, we will put 10ETH+25000USDT into the pair of ETH/USDT, which is equivalent to placing 10ETH orders continuously above the price of 2500 to sell, and placing 25000 USDT orders continuously below the price of 2500 to buy. When the price goes up, LPs keep selling ETH. The mathematical relationship of the ETH selling ratio y caused by the change in price p in CFMM is:

When the price goes up to the (1+r) of original price, the amount of LP selling ETH is:

For example, when the price of ETH drops to 1600, the LP token at this time contains 12.5ETH+20000USDT (regardless of the fees and reinvestment). 12.5 ETH is equivalent to distribute evenly above 1600 according to CFMM and ready to sell, while 20000 USDT is placed below 1600 and ready to buy. That is, the original 5000 USDT buy order of LP is converted into the continuous sell order of 2.5ETH in the price range of [1600,2500] (here we define the buy order refers to the buying ETH order), and the price range outside [1600,2500] has no change in liquidity. The density and direction of continuous pending orders in the equivalent model have also not changed.

It could be found that when LP puts two equivalent tokens into the pair, it is actually a form of recognition of the current price. When the price rises, LPs are willing to sell, and when the price drops, LPs are willing to buy. No matter whether the price rises or drops, LPs will incur impermanence loss (IL), that is, the difference between holding the two tokens, which requires the LP’s transaction fees to make up for it.

When we consider the subsidy of governance token distribution to the above-mentioned LPs, we find that the token distribution subsidy will compensate for the impermanence loss of LP together with the handling fee. Only when the sum is greater than the expected impermanence loss, can LPs be motivated to provide liquidity. Mathematically, it can be deduced that the boundary condition is (assuming that the price of the governance token drops by a):

Among them, the equivalent number of price fluctuations during the observation period is N, and the swap fee ratio is b. Subsidy is evenly distributed to Token Valued Locked (TVL).

The strategy of governance token distribution along with liquidity mining should follow the two rules below:

1. Incentive Rule: The subsidies of token distribution together with the trading fee needs to be larger than impermanence loss to attract LP to participate, That is, the above boundary conditions need to be met.

2. Beneficial Rule: Once LP participates, the value of the project and governance token should be improved. That is, the liquidity provided by LP is more valuable to the system than the distributed platform currency.

As for the pair of governance token — mainstream currency like USDT, the part of mainstream currency liquidity provided by LP will become the counterparty of the trend of governance token dropping, that is providing buy orders from the current price to 0. This part of the liquidity is welcomed by communities and supports the value of the project.

While the governance token provided by LP will become the obstacles of price rising. That is, liquidity of the governance token is equivalent to provide sell pending orders from the current price to positive infinity. The communities are unwilling to see that and in the meantime liquidity providers suffer the impermanence loss when the price rises.

Based on the analysis above, it will be beneficial to LPs and communities if LPs could have the opportunities to provide only single-side liquidity of the pair, which could be achieved in Uniswap V3.

3. Opportunities brought by Uniswap V3 by providing half of liquidity to token distribution

  1. From zero to current price
  2. From a certain price to the current price
  3. From zero to a certain price (lower than the current price)
  4. From a certain price to a certain price (lower than the current price)

Since the LP obtained NFT (Non-Fungible Token) after adding liquidity, the governance token can not be distributed evenly according to the amount of LP token. It is necessary to comprehensively design a novel mechanism to reward LPs holding NFT transparently and fairly. Here are two of the principles for design:

1.Loyalty Principle: The closer the price range to the current price, the higher the subsidy ratio of token distribution received.

From the perspective of impermanence loss, the selection of different ranges also shows the vote of LPs, which reflects what Vitalik said “Uni should become the oracle token”.

2. Fairness Principle: Subsidy ratio of governance token distribution should be the same withIn the same price range, platform currency.

It should be noted that the strategy of token distribution along with liquidity mining in the V2 mode does not conflict with the V3 mode.

Here we give an example of token distribution strategies based on Uniswap V3. Suppose there is a decentralized exchange called V3Dex, who adopts the same concentrated as Uniswap V3, and the governance token is V3D. There is a V3D-USDC trading pair on the platform, and the current price is 1 V3D=100USDC.

3.1. Single fixed price range strategy:

According to the definition of Uniswap V3:

We could find if the current price is larger than or equal to the upper bound of the price range , LP only does not need to provide V3D and . The governance token will be distributed according to the amount of provided USDC placed in the price range:

After the price range is fixed, the current price may change and enter the fixed price range changes. At this time, if LP withdraws liquidity, LP will receive USDC and V3D token respectively. If users wish to add liquidity to the fixed price range, they need to add both USDC and V3D tokens at the same time according to the corresponding proportion.

Single fixed price range strategy is easy to use and encourages LP provides mainstream currency into the trading pair and supports the price of governance token.

3.2. Multiple fixed price range strategies:

Before liquidity mining starts, the project can also set multiple fixed price ranges. For example, in the above case, the subsidized price range is (0,100), (0,25), (25,100) and the governance token distribution is made according to the liquidity in these ranges.

It should be noted that multiple fixed price range strategies need to meet incentive compatible rules to avoid the arbitrage situation, where LP provides liquidity to a combination of several fixed price ranges and it performs significantly better than another combination. For example, if the subsidy ratio of (0,100), (0,25), (25,100) are 1:1:2, the LP of (0,100) has the motivation to withdraw all liquidity and placed back to (0,25) and (25,100) equally to achieve a 50% increase of subsidy without increasing any potential risk of impermanence.

Generally speaking, multiple fixed price range strategies should follow the token distribution subsidy ratio Sr​ as:

3.3. Variable price range strategies:

Taking the above case as an instance, the initial price is 100, and the initial LP invests 100 USDC to the initial subsidy price range (0,100) for liquidity mining. As the price changes, if the current price is lower than the initial price upper bound, for example the updated subsidy price range gets to (0,25), and the LP entering from the beginning will hold 50 USC and 2 V3D at this time, which is equivalent to adding liquidity of 50 USDC into (0,25) and 2 V3D into the (25,100) price range. At this time, since the subsidy strategy of changing price range is implemented, only the (0,25) price range can be subsidized, and the corresponding subsidy of governance token distribution of initial LP provides is reduced by half.

If the current price changes higher than the initial price range upper bound, for example, 200, the updated subsidy price range is (0,200), and the initial LP still holds 100 USDC within the subsidy price range and the subsidy can be obtained. It should be noted that under the variable price range strategy, the price range set by the LP only needs to be a subset of the subsidized price range to obtain incentives. In order to encourage the LP to provide more market liquidity around the current price, in most cases the non-uniform subsidy ratio strategy will be adopted, and the common non-uniform subsidy ratio is set as:

Combined with the subsidy equation in 3.2, we can get:

4. Conclusion

At the practical level, Uniswap V3 is currently only deployed on Ethereum, and it is planned to be deployed on the Ethereum side chain Arbitrum. Since Uniswap V3 has applied for license protection for the core code, it is difficult for us to see the huge emergence of forked projects on all chains as before. So to use the single-side strategies, if the project is deployed on Ethereum or Arbitrum, it is recommended to call the Uniswap V3 smart contract directly. If the project is deployed on other public chains, you can also use the bridging method to connect across the chain,instead of building by yourself.

Reference:

[2] Hayden Adams, UniSwap whitepaper, 2020

https://hackmd.io/@HaydenAdams/HJ9jLsfTz

[3] Jimmy Yin, Comparison between Uniswap V2&V3 and improved liquidity mining strategies

https://docs.izumi.finance/comparison-between-uniswap-v2-and-v3-and-improved-liquidity-mining-strategies

Programmable Liquidity as a Service on Uniswap V3 and multi-chains Discord:http://discord.gg/hVaCnGx3Zs Telegram:http://t.me/izumifinance