Weakness of V2 DEXs: Low Liquidity utilization rate
Since Uniswap rolled out the CPMM AMM DEX model (UniSwap V2) based on x*y=k, it prompted many other similar DEXs to follow along the similar path. V2-type DEXs enabled sufficient on-chain market-making with lower gas fees and gave rise to a new type of economic entity – the liquidity providers. However, V2-type liquidity provision is often equated with a low liquidity utilization rate, which means most of the added liquidity is not used for the swaps.
Operating Principle of V2 DEXs
V2-type CPMM DEXs calculate the swap ratio to ensure that the multiplication of X and Y tokens provided to the liquidity pool remains constant.
Let’s say you are swapping 20,000 USDT into BTC for a liquidity pair with (2 BTC, 80,000 USDT) of liquidity when the price for 1 BTC is 40,000 USDT. This is how the swap would go:
(2 – swap output)*(80,000 + 20,000) = 160,000
2 – swap output = 160,000/(80,000+20,000) = 1.6
Pool Liquidity after swap : 1.6 BTC, 100,000 USDT
Price after swap : 1 BTC = 62,500 USDT
V2-type DEXs which follow the above swap rules offer swaps at all price ranges (from zero to infinity) for the X and Y token pairs.
This V2-type liquidity provision and swap mechanism converted into a more familiar order book type illustration would look like this:
Utilizing the liquidity provided by LPs, sell/buy orders will be created across all price ranges, and traders will execute swaps for the orders created by the LPs. During this process, traders will pay a part of the swap amount to LPs in the form of a swap fee, which would become the income yields for LPs.
Low Profitability Arising from Low Liquidity utilization rate
LPs provide liquidity to the protocol for a particular period and claim interests in return, which originally comes from the swap fee that traders pay in proportion to the total swap volume. Therefore, the bigger the swap volume is, the higher the interest will be for the LPs.
But bear in mind – V2-type DEXs typically have low liquidity utilization rates, meaning that not all of the liquidity provided by the LPs is used for the actual swaps.
Let’s take a look at the below example case:
The liquidity is distributed throughout all price ranges (0, ∞) evenly and shallowly. However, since the actual swaps only take place within a limited number of price ranges, most of the liquidity is not utilized for the swaps, creating the following issues:
LP’s yielded income would be limited, as only a tiny proportion of the liquidity they provided will be used for the swaps.
Price impact and slippage are made bigger due to shallow swap liquidity.
Asset flow within the ecosystem will be tightened as most of the liquidity bound in the DEXs are not actively utilized.