The New UNI Staking Model: Implications for DeFi

Uniswap is a decentralized exchange leading the list of the largest DEXs by daily trading volume ($1.4 billion). The exchange facilitates token swaps on Ethereum, Arbitrum, Optimism, and other blockchains.

Top 5 DEXs by daily trading volume. Source: coinmarketcap.com

In September 2020, Uniswap announced the launch of its native platform token, UNI, designed for protocol governance through voting on strategic partnerships, updates, etc. 

The proposed revision to UNI staking aims to transition the token's role from governance to rewards, enhancing Uniswap's governance framework by fostering more active and meaningful participation in UNI delegation.

Erin Koen, the governance lead who proposed this initiative, notes that a mere 10% of all UNI in circulation are utilized for voting purposes. Furthermore, he critiques the prevailing delegation method as “stale.”

“As of February 1 2024, 14 of the top 30 delegates by voting power had not voted over the last 10 proposals, and only 7 of these delegates have ever created a proposal,”  Erin wrote.

This piece delves into the specifics of the update and its prospective influence on the DeFi landscape.

Update Details

Before diving into the specifics of the potential Uniswap upgrade, it's crucial to understand the function of liquidity pools and the protocol's fee-generation mechanism.

Uniswap operates as a decentralized exchange using an automated market maker (AMM) algorithm, meaning users don't have to wait for matching orders: the liquidity (the required amount of tokens for buying/selling) is already present in the liquidity pools.

Liquidity providers are essential to the protocol's functionality. They lock their desired amount of tokens in liquidity pools, enabling other users to instantly buy or sell tokens. For their services, they receive rewards (typically 0.3% per pool) from all transactions conducted in their pool.

How Uniswap liquidity pools work. Source: docs.uniswap.org

The latest proposal submitted to the Uniswap DAO aims to modify the rewards distribution principle. Rewards will now be part of the liquidity pool fees, with their allocation controlled by DAO members, such as 0, 1/4, 1/5, 1/6, 1/7, 1/8, 1/9, or 1/10. Currently, this rate is zero.

This update is expected to be facilitated through two smart contracts: 

• V3FactoryOwner.sol: Facilitates automated, permissionless collection of protocol fees from pools where they accumulate.
• UniStaker.sol: Oversees delegation and fee distribution.

Each contract features adjustable parameters, expected to be set by DAO governance, though the Uniswap Foundation (UF) has already offered its recommendations. Future discussions will build on these suggestions.

Fees are collected in V3FactoryOwner.sol and upon reaching a certain threshold, are transferred to UniStaker.sol, which handles staking and distributes tokens to delegators. 

The speed of fee distribution to UNI stakers, along with the size of their rewards, is determined by variables such as:

• Reward Token: The currency in which UNI stakers' rewards are denominated. UF suggests using WETH (Wrapped ETH), enabling the collection of an equivalent ETH amount from liquidity pools across blockchain networks.
• Reward Amount: The fee level at which rewards are distributed among stakers. The higher this threshold, the less frequently stakers receive their rewards.
• Reward Duration: The timeframe over which rewards are distributed.
• Staker’s Share in Total UNI Staking: Stakers earn rewards in proportion to their share in the total UNI staking pool. 

Trade volume is another factor that influences the rewards distribution mechanism—the greater the volume, the quicker the reward threshold is reached.

Whenever this occurs, the “reward duration” resets, and undistributed rewards are added to the newly reached sum. 

For instance, consider a scenario with:

• Reward Token: WETH;
• Reward Amount: 10 WETH;
• Reward Duration: 30 days.

If you've staked 15 UNI and are the sole participant, your share amounts to 100% of the total UNI staking. Assume that on the next day, user transactions reach the 10 WETH reward threshold. Consequently, your daily reward would be 0.33 WETH (10 WETH / 30 days).

Imagine that over the next three days, the reward amount reaches 10 WETH again. Since you've already earned roughly 1 WETH (at 0.33 WETH per day), the remaining 9 WETH is added to the new 10 WETH, yielding a daily reward of 0.633 WETH (19 WETH / 30 days).

Should your friends join you in staking UNI, profits would be divided based on each participant's share. For example, if Alex locks 10 UNI, Anna 20 UNI, and Max 5 UNI, you would receive 0.1899 WETH (30%) per day, Alex 0.1266 WETH (20%), Anna 0.2532 WETH (40%), and Max 0.0633 WETH (10%).

The Impact of the Uniswap Update on DeFi

The initiative to revamp UNI staking rewards has not only increased Uniswap's visibility across social networks but has also influenced the price of its token along with other DeFi project tokens. It's noteworthy that on February 23, UNI's price experienced an 81% surge, DYDX increased by 21%, CAKE by 17%, SNX by 13%, and CRV by 14%. 

A comparison of UNI's price growth with other DeFi tokens on February 23, 2024. Source: tradingview.com

The voting process will be initially hosted on the off-chain platform, Snapshot, before making its debut on the blockchain on March 8, 2024.

To assess the impact of this update, let's estimate the potential profit distribution among UNI stakers following the initiative's implementation:

• Uniswap's fees over the past 30 days amounted to $78.5 million.
• A portion of these fees earmarked for UNI stakers ranges from 1/4 to 1/10.

Given that staking rewards are usually represented as APR (annual percentage rate), annualizing the initial figure results in $942 million in fees. Consequently, allocating 1/4 of these fees for stakers would yield rewards of $235.5 million, while a 1/10 allocation would result in $94.2 million.

For perspective, let's compare this to the staking rewards for other tokens:

• Ethereum has 30.9 million ETH staked, with an average APR of 4%, totaling annual rewards of 1.2 million ETH (roughly $4.1 billion).
• Polkadot has 675.4 million DOT staked, with an average APR of 8%, totaling annual rewards of 54 million DOT (around $461 million).
• Cosmos has 253.6 million ATOM staked, with an average APR of 9%, totaling annual rewards of 22.8 million ATOM (approximately $260 million).

The exact number of participants who will stake UNI remains unknown, making it challenging to determine whether UNI staking will be more lucrative than DOT or ATOM staking. However, the prospect of UNI staking rewards being comparable to those for ATOM indicates a potential surge in interest among stakers toward UNI.

Following the update, UNI will take on more characteristics of a security than a governance token. Just as owning certain types of company shares entitles shareholders to dividends from profits, staking UNI will allow participants to earn from fees.

This initiative likely suggests Uniswap's readiness to face potential scrutiny from the SEC. The shift to this rewards format has led many in the community to anticipate regulatory inquiries. 

Not only does this update have implications for Uniswap, but it also impacts other exchanges. Uniswap, much like Apple in the realm of smartphones, sets trends within the DEX landscape. Should this initiative be adopted, platforms such as dYdX, PancakeSwap, and Frax might find themselves moving towards similar staking monetization methods. Indeed, these platforms have already expressed curiosity about this model on X (formerly known as Twitter).

Should the update take place and other projects follow suit, it would lead to a reassessment of their token values. Consequently, UNI would become more valuable, attracting more users to purchase and hold the token.

Despite the optimistic market changes, there are concerns within the community about potential downsides:

• Uniswap Centralization: Concentrated UNI staking among large pools could disproportionately influence DAO decisions.
• Liquidity Providers' Exodus: The commission earmarked for stakers represents potential earnings lost by liquidity providers. Post-update, many may switch to other DEXs offering better terms, potentially reducing liquidity on Uniswap.

This reduction in liquidity could lead to slippage for some users, where transactions are executed at a price different from the intended one. Thus, in this scenario, Uniswap risks losing not just liquidity providers but traders as well.

Final Thoughts

The proposal's acceptance is expected to attract new stakers to the protocol. Since existing delegates would need to redelegate their tokens, there's a possibility of reinvigorating the least active among them. However, the question remains: Will the update be adopted? Only time will tell. 

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