NFTs are growing in popularity, and the use cases of NFTs in the financial ecosystem of decentralized finance (DeFi) is growing as well. In this article, we focus on the financial NFTs, specifically UniSwap v3 liquidity NFTs.
Uniswap is one of the oldest Decentralized Exchanges (DEXs) in the DeFi ecosystem. It was initially only on Ethereum Main Net but has since moved cross-chain to Polygon and layer two blockchains such as Optimism and Arbitrum.
Last week, Petri Basson released an article detailing how DEXs liquidity providing and LP tokens work. This is an excellent read to start with before jumping into this article. But to recap in short, DEXs allow users to trade assets in a decentralized manner with the help of liquidity pools. Other users can lock up their assets in a liquidity pool and receive a LP token as proof of assets that they locked into the liquidity pool. With these LP tokens, users can lock them up in DeFi protocols and earn passive income. But LP tokens themselves are limited to the functionality of the ERC20 token standard and cant have extra functions built on top. In comes financial NFTs and how Uniswap has implemented them in their Uniswap v3 ecosystem.
Now that the basics of liquidity pools have been covered, we can progress into the liquidity NFTs and what functionalities they add.
While previous liquidity pools use the price curve structure to determine pool price depending on the volume of each asset in the pool with a distribution between 0 and infinity, uniformly along the price curve.
Liquidity Price Graph
Uniswap v3 allows for the concentration of the liquidity providers’ assets to specific points on the price curve. Following the ERC20 token standard, the previous LP tokens do not have this functionality. Still, by representing the liquidity position as NFTs, users can add extra limits to their liquidity.
Concentrated Liquidity NFTs
With concentrated liquidity NFTs, liquidity providers can select the price ranges they want their liquidity to fall under and only providing their liquidity to these desired price ranges. With the liquidity NFTs users can also provide their liquidity to multiple price ranges, this was not something a user could do in Uniswap v2. For example, a user can provide $1000 worth of liquidity to the price range of $2000 – $2500 in the ETH/USDC pool and an additional $5000 to the ranges $3000 -$4000. By doing this the user’s liquidity NFTs can approximate the shape of any automated market maker (AMM) or active order book (normally found with in a centralized exchange). One of the main reasons why providing concentrated liquidity ranges within the liquidity NFTs are so powerful is that it provides the same liquidity depth as standard LP’s in v2 but with in a specified range while putting far less capital at risk when large market movements occur.
When market prices move outside a liquidity NFTs specified price range, the liquidity is effectively removed from the pool and is no longer earning fees. During this state, liquidity NFTs liquidity is composed entirely of the less valuable of the two assets, until the market price moves back into their specified price range, or they decide to update their range to account for current prices.
Users can also provide different swap fees to each of these ranges, by increasing their amount of fees earned for providing liquidity. The liquidity NFTs can be traded on secondary markets, as the owner of the NFT is entitled to the underlying assets that this NFT represents.
Liquidity NFT Problems:
With the above information in mind and understanding a bit more of the power of liquidity NFTs we can see a few problems regarding the collection of data for accounting and auditing purposes.
Standard LP tokens are easy to track on the blockchain as they follow the ERC20 standards and we at HASH Data have already built out the data collection services to track these LP tokens. Now NFTs need to be tracked for Uniswap v3 liquidity positions and if they are put on auction in secondary markets these liquidity positions still need to be monitored as the NFTs represent the underlying assets that were locked up in the liquidity pool.
We at HASH Data have spent a lot of time looking at blockchain data and we are adding functionality that will allow our software to collect all NFTs and drill into the liquidity NFTs underlying positions and price ranges where the liquidities are provided. When more secondary markets emerge, we will also be able to track the liquidity NFTs that are on auction and the actual composition of the underlying assets they represent at any given time.
Feel free to contact HASH Data if you would like to learn more.
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