On August 22, 2022, decentralized exchange Trader Joe launched its v2. It is called Liquidity Book, and it promises traders the option to provide liquidity for a specific price range. Another perk is compensation in the form of higher trading fees when there is high price volatility. Both help with offsetting the risk of impermanent loss. It’s clear that Trader Joe has taken a good look at Uniswap v3 and tried to improve on it.
About Trader Joe
Trader Joe is a multi-functional defi platform that includes services like an NFT marketplace. Its decentralized exchange (dex), which is the topic of this article, is in the top 20 dexes. Since its launch on Avalanche in July 2021, it has generated a trading volume of more than $88 billion. Trading fees are paid to both liquidity providers and JOE token holders.
However, Trader Joe found that its v1 design caused its users capital inefficiency and impermanent loss. The v2 is a response to this.
Introducing Concentrated Liquidity: Providing liquidity in a price range
Concentrated liquidity was introduced by Uniswap v3. It allowed liquidity providers (LPs) to take positions in a certain price range for a trading pair. This increases the efficiency with which LPs can deploy (and risk) their capital. It allows them to deploy refined strategies as opposed to just dumping their coins in a pool and hoping for the best.
Like Uniswap v1, Joe v1 was built on the popular x*y=k Automated Market Maker (AMM) design. And following in the footsteps of Uniswap’s introduction of concentrated liquidity in v3, TraderJoe comes with a similar architecture. In Liquidity Book, liquidity is separated into distinct price ranges or ‘bins’. This is analogous to Uniswap v3’s Ticks. (I wonder why Trader Joe didn’t call these bins ‘pages’, to stay in the book metaphor?).
Example of Trading in Bins
Let’s compare trading between the first and current version of Trader Joe.
- Joe v1: A LP can deposit liquidity into the USDC/ETH pool and the liquidity will be spread over $0 to infinity price range.
- Joe v2: LP’s can set a price range of 1600 to 1700 USDC per Ether in the USDC-ETH pool. The liquidity they provide will only accrue trading fees as long as Ether trades in that range.
The most eye-catching benefit? In v2, the fees will be higher than in v1, where the price range is infinite. According to Joe’s explanation of Liquidity Book, ‘Concentrated Liquidity leads to traders getting considerably better prices with reduced or even zero price impact, even in pairs with relatively low TVL.’
Traders who want to benefit from high fees and who whave conviction in a certain price range can deposit all their tokens into one range, or ‘bin’. Others will opt for a more balanced approach. Depending on their view of the market, they can pick any amount of specific bins, and deposit any amount of liquidity into those bins.
Another benefit that Trader Joe claims the bin structure provides, is reduced or even zero price impact (slippage) of trades, even in trading pairs with small pools. Joe claims that this makes it stand out above Uniswap v3, in which slippage can still occur.
The Difference with Uniswap v3: Adjusting positions in one transaction
TraderJoe’s core team has apparently had a good look at what could be improved on Uniswap’s v3. They came up with so-called fungible token receipts for assets deposited into pools. These receipts allow traders to easily re-balance positions in one transaction. Whereas on Uniswap v3, for example, it would take several transactions to adjust one position. This is of course a vital feature for traders who provide concentrated liquidity. As the price moves, they want to reassess and adjust the range in which they provide liquidity. TraderJoe hints at the future automation of this position management, by so-called automated vaults.
Variable Fees to Compensate for Volatility Risk
Especially for volatile trading pairs, providing liquidity comes with a high risk of impermanent loss. That’s the case when simply holding the coins of the trading pair would have resulted in higher returns than putting them in the pool (since the pool gets rebalanced, traders would lose some of their highest returning coins).
A first way to deal with this risk is the above idea of concentrated liquidity: if ETH pumps and goes higher than the top of the range you chose, you automatically no longer take part in that bin of the pool.
Another way to compensate LP’s for the volatility risk is simply by… paying them more trading fees. Joe v2 has an algorithm (the volatility accumulator) that assigns the current price volatility a score. If volatility is high, the fee ramps up to compensate users for costs associated with liquidity provision (see the video).
Conclusion: New generation of AMM’s upon us
The first generation of automated market makers were not great in terms of capital efficiency/ profitability for LP’s. With the new generation of dexes like Uniswap v3 and Joe v2, the option of active strategies could unlock the next level of DeFi adoption. If done with precision, active management of providing liquidity can lead to a huge increase in trading fees. Uniswap v3 has already proven this and Joe’s Liquidity Book builds upon it.
That would mean that the age of passive market making in defi is over. Instead, active strategies – and soon, services that automate these strategies for you – will become the norm.
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