Author: YBB Capital Researcher Zeke

Preface

For Web3, I believe there are three key historical moments: Bitcoin pioneered the decentralized blockchain system; Ethereum introduced smart contracts, which expanded the use cases of blockchain beyond payments; and UNI, by decentralizing financial privileges, ushered in the golden age of blockchain. From V1 to V4, from UNI X to UNI Chain, how far is UNI from being the ultimate answer for DEX?

UNI V1: The Prelude to the Golden Age

Before UNI, decentralized exchanges (DEXs) existed, but it wasn’t until after UNI’s arrival that they could truly be called decentralized. Many articles attribute UNI’s success to its simplicity, security, privacy, and its pioneering of the automated market maker (AMM) model. However, in my view, aside from its simplicity, these other factors played a relatively small role in UNI’s rise. Contrary to popular belief, UNI was not the first to adopt the AMM model. Bancor, the second-largest ICO project in blockchain history, implemented the AMM model before UNI. Furthermore, on-chain exchanges using an order book model had already been established before UNI. So, why did UNI, not being the first mover or the only exchange offering security and privacy, manage to outpace its predecessors?

Let’s first talk about Bancor, which existed before UNI and was once a top-tier on-chain exchange. Bancor provided algorithms or protocols for issuing assets, such as those used by the once-popular EOS RAM and IBO (Bancor’s protocol is the “B” in IBO). Bancor was also the first to implement the constant product market maker (CPMM) model, widely recognized in decentralized finance. There are many explanations for Bancor’s eventual downfall compared to UNI, ranging from U.S. regulatory issues to inferior user experience and even debates over the mechanics of the protocols. However, I won’t delve too deeply into these reasons because, in my understanding, UNI’s success boils down to one simple fact: it was the first DEX to truly fit the definition of decentralized finance (DeFi).

The AMM model was the only mechanism at the time that could democratize market making and asset issuance. In contrast, on-chain order book models or hybrid exchanges couldn’t allow users to freely list tokens or participate in liquidity provision for profit. These exchanges typically suffered from slow trade execution and a lack of trading pairs. Bancor, despite using the AMM model, still failed because its liquidity was rigid, and listing tokens required approval from Bancor’s team, along with payment of listing fees. This meant the project still revolved around decisions made by a centralized entity and did not truly return control to the users.

From my perspective, UNI’s early versions were not particularly user-friendly. Short-term price volatility was high (an inherent issue with CPMM, where large trades could manipulate prices temporarily), ERC-20 tokens couldn’t be swapped directly, leading to slippage, gas fees were high, there was no slippage protection, and advanced features were lacking. While AMM solved the liquidity and slow execution issues of order book-based DEXs, it still couldn’t compete with centralized exchanges (CEXs). Early users of UNI V1 were few, but its significance was historic. It was the first time financial democratization was reflected in a DEX, allowing anyone to list tokens without barriers and enabling the public to provide liquidity for a decentralized exchange. Thanks to UNI, meme tokens have become widespread, and projects without top-tier teams can thrive on the blockchain. Financial privileges once reserved for large institutions are now accessible across the blockchain ecosystem.

UNI V2: DeFi Summer

UNI V2 was launched in May 2020. At that time, UNI V1’s total value locked (TVL) was under $40 million, far from the DeFi giant we see today. The V2 upgrade addressed many of V1’s shortcomings, such as short-term price manipulation and the need for ETH as an intermediary in token swaps. UNI V2 also introduced flash swaps to enhance practicality. The most notable improvement was UNI’s approach to combating price manipulation.

UNI introduced the “last price” mechanism, where the final transaction price of a block determined the price for that block. This meant attackers needed to complete trades at the end of one block and finalize their arbitrage in the next block, a process requiring selfish mining (concealing blocks from the network) and the ability to mine two consecutive blocks — an almost impossible task, making manipulation highly costly and difficult. Another significant feature was the introduction of the time-weighted average price (TWAP). Unlike a simple average of recent block prices, TWAP weights prices based on how long they persisted.

For example, if the price of a token pair over the last three blocks were as follows:

• Block 1: Price 10, duration 15 seconds

• Block 2: Price 12, duration 17 seconds

• Block 3: Price 11, duration 16 seconds

At the end of Block 3, the weighted sum would be: 10 * 15 + 12 * 17 + 11 * 16 = 488. To calculate the TWAP, it would be 488 / (15 + 17 + 16) ≈ 11.11. This weighting reduces the impact of brief price fluctuations, meaning an attacker would need to manipulate prices for an extended period to affect TWAP, making it even harder and more costly to manipulate prices.

This approach can be seen as an early way to combat miner extractable value (MEV), and it made AMMs more secure and reliable. As a result, UNI gradually became the mainstream choice for on-chain DEXs. Along with internal improvements, there were also external factors at play. One key event in June 2020 catalyzed the golden age of blockchain: the advent of DeFi Summer. This period began when the lending platform Compound Finance started rewarding both borrowers and lenders with COMP tokens. Other projects followed suit, creating what came to be known as “yield farming” or “liquidity mining” opportunities. As a DEX with low barriers to listing and the ability to provide liquidity, UNI naturally became the go-to platform for all sorts of yield farming projects. The influx of liquidity during this “gold rush” solidified UNI’s position at the top of DeFi. By April 29, 2021, UNI V2’s TVL peaked at over $10 billion. DeFi had gained widespread recognition, and blockchain was on its way to mainstream adoption.

UNI V3: The Long Road to Competing with CEXs

By the time UNI reached its V2 version, it had already become the standard model for AMM-based DEXs. It’s safe to say that 99% of similar projects at that time had core architectures almost identical to UNI. At this point, UNI’s competitors were no longer other DEXs but centralized exchanges (CEXs). One of the major problems with the AMM model compared to the efficiency of CEXs was its low capital efficiency. For ordinary users, providing liquidity for non-stablecoin trading pairs posed a significant risk of impermanent loss. During the DeFi Summer of 2020–2021, it was not uncommon for users to lose their entire principal while trying to chase liquidity mining rewards. The best way to mitigate this risk was to provide liquidity for stablecoin pairs like DAI-USDC, which led to a large portion of TVL being tied up in assets with limited actual utility. Another inefficiency in V2 was that liquidity was spread evenly across the entire price range from 0 to infinity, even for price ranges where no trades occurred, leading to inefficient capital utilization.

To address these issues, UNI introduced Concentrated Liquidity in V3. Unlike in V2, where liquidity was distributed evenly across the entire price range, V3 allowed liquidity providers (LPs) to concentrate their funds within specific price ranges of their choosing. Liquidity was only deployed within the selected price range rather than being spread across the entire price curve. This allowed LPs to provide the same liquidity depth with less capital or provide greater liquidity depth with the same amount of capital. This model was particularly beneficial for stablecoin pairs that traded within narrow price ranges.

However, in practice, V3 did not perform as well as expected. Most users chose to provide liquidity in the price ranges where they anticipated the most volatility, which meant that high-yield price ranges became overcrowded with liquidity, while other ranges still lacked sufficient liquidity. Although individual LPs saw increased capital efficiency, the overall distribution of funds remained uneven, and the inefficiencies of V2 persisted. In terms of liquidity efficiency, V3 lagged behind the pricing boxes proposed by Trader Joe, and for stablecoin pair optimization, it was inferior to Curve. With Layer 2 solutions on the horizon and order book-based DEXs potentially reclaiming dominance, UNI had yet to achieve its dream of dethroning CEXs and was instead facing a “midlife crisis.”

UNI V4: A New Era of Customization

UNI V4 was a major update released two years after V3, and we have analyzed it in greater detail in our previous reports. Here, I’ll provide a brief overview. Compared to the V3 version from two years prior, V4 focused on customization and efficiency. V3’s introduction of concentrated liquidity improved capital efficiency, but the need for LPs to precisely select price ranges created some limitations. In extreme market conditions, liquidity could still become insufficient. Meanwhile, protocols like Curve and Trader Joe offered better solutions for some trading scenarios.

V4 aimed to strike the best balance between customization and efficiency, surpassing both competitors in precision and capital utilization. The most significant innovation in V4 was the introduction of the Hooks mechanism, which granted developers unprecedented flexibility. Hooks, which are also smart contracts, allowed developers to insert custom logic at critical points in the liquidity pool lifecycle, such as before/after a trade or when an LP deposits or withdraws funds. This enabled the creation of highly customized liquidity pools, supporting features like time-weighted average market makers (TWAMM), dynamic fees, on-chain limit orders, and integration with lending protocols.

Additionally, V4 replaced the Factory-Pool architecture, which had been in use since V1, with a Singleton architecture. This change consolidated all liquidity pools into a single smart contract, allowing developers to build more complex and modular structures. It also significantly reduced the gas costs of creating liquidity pools and executing cross-pool trades (reducing gas costs by up to 99%) and introduced a “Flash Accounting” system to further optimize gas efficiency. As a bear market update in late 2023, UNI V4 helped UNI regain some ground in the increasingly competitive AMM landscape.

However, V4’s high degree of customization also introduced new challenges. Developers now needed more technical expertise to fully leverage the Hooks mechanism, and they had to be cautious in designing pools to avoid security vulnerabilities. Additionally, the highly customized liquidity pools could lead to market fragmentation, reducing overall liquidity. In summary, V4 represented an important direction for the development of DeFi protocols, focusing on highly customizable and efficient automated market-making services.

UNI Chain: Towards Maximum Efficiency

UNI Chain is a recent major update that signifies the potential future direction of DEXs, which may evolve into their own blockchains (though it is puzzling that UNI Chain is not an application-specific chain). Built on Optimism’s OP Stack, UNI Chain aims to enhance transaction speed and security through innovative mechanisms, ultimately capturing value for UNI token holders. Its core innovations focus on three main aspects:

1. Verifiable Block Construction: By leveraging Rollup-Boost technology in collaboration with Flashbots, along with Trusted Execution Environments (TEE) and Flashblocks mechanisms, UNI Chain enables fast, secure, and verifiable block construction. This reduces MEV (Maximal Extractable Value) risks, speeds up transactions, and offers rollback protection.

2. UNI Chain Validator Network (UVN): Validators are incentivized through UNI token staking to participate in block validation, addressing the centralization risk of single sequencers and enhancing network security.

3. Intent-Driven Interaction Model (ERC-7683): This model simplifies the user experience by automatically selecting the optimal cross-chain transaction path, resolving issues related to liquidity fragmentation and the complexity of cross-chain interactions. It is compatible with both OP Stack and non-OP Stack chains.

In simpler terms, these innovations focus on anti-MEV measures, decentralized sequencing, and user experiences centered on intent. UNI’s inclusion in the OP Superchain strengthens the influence of the OP alliance, though this may pose short-term challenges for Ethereum. The departure of a core protocol (with UNI accounting for 50% of Ethereum’s transaction fees) adds strain to Ethereum’s already fragmented ecosystem. However, in the long run, this could be a crucial opportunity to test Ethereum’s fee model.

Conclusion

Currently, as DeFi application infrastructure has surpassed performance requirements, many DEXs are shifting toward the order book model. While AMMs are simpler than order book models, they will never match the capital efficiency of order books. Does this mean AMMs will disappear in the future? Some believe AMMs are merely a product of a specific era, but I think AMMs have become a symbol of Web3. As long as memes exist, AMMs will persist. As long as there is grassroots demand, AMMs will have a place. One day, we may see UNI overtaken or even introducing order books, but I believe this symbol will always remain.

On the other hand, UNI itself is becoming increasingly centralized. Its governance has seen a16z exercise “veto power,” and fees are being charged at the frontend without informing the community. We cannot deny that Web3’s evolution is increasingly diverging from ideals of decentralization and the realities of human nature. How we coexist with these giants that have grown so rapidly is a question we must all consider.

About YBB

YBB is a web3 fund dedicating itself to identify Web3-defining projects with a vision to create a better online habitat for all internet residents. Founded by a group of blockchain believers who have been actively participated in this industry since 2013, YBB is always willing to help early-stage projects to evolve from 0 to 1.We value innovation, self-driven passion, and user-oriented products while recognizing the potential of cryptos and blockchain applications.

Website | Twi: @YBBCapital

References:

1. Uniswap Documentation: https://docs.uniswap.org/

2. Reevaluating Bancor Algorithm: Why Constant Weight is a Flawed Design: https://www.jinse.cn/bitcoin/249008.html

3. UniswapX Research Report: Summarizing the Development Path from V1 to V3, Analyzing the Innovations and Challenges of the Next-Generation DEX: https://news.marsbit.co/20230729110055842724.html

4. Uniswap: From Zero to Infinity: https://www.techflowpost.com/article/detail_14863.html

5. YBB Capital: Farewell to Fork Swaps, Is Uniswap V4 Entering the Era of Custom Hooks?: https://www.odaily.news/post/5188061