Uniswap’s Proposed ‘Fee Switch’ Would Cut Into Liquidity Provider Payouts

The community governance process that oversees decentralized cryptocurrency exchange Uniswap is currently discussing whether or not it should implement a “fee switch.”

Uniswap currently imposes a 0.3% fee for trading tokens on the platform. Revenue generated by the fee is immediately placed into liquidity reserves, and liquidity providers (LPs) receive a payout dependent on their contribution to the liquidity pool.  

The proposed fee switch, otherwise known as the protocol charge, would direct 0.25% of the 0.3% fee to LPs, and the remaining 0.05% will supposedly go to UNI token holders.

“Uniswap governance proposals like this one must go through and pass the Uniswap community governance process prior to being enacted,” a Uniswap Labs spokesperson said. “The Uniswap community will decide whether this proposal passes or not.”

At the time of writing, Uniswap’s 24-hour trade volume is a little over $1.2 billion, ranking it the top DEX (decentralized exchange) by volume. This number is still significantly less than top centralized exchange Binance’s 24-hour trade volume, which reached almost ​​$13.8 billion, implying that traders are still prioritizing centralized exchanges over decentralized ones. 

So far, the only certain thing is that the “accumulated protocol fees can be collected by UNI governance.” But UNI token holders have long envisioned a portion of the protocol fees eventually accruing to DAO members — similar to rival DEX Sushi, which employs a staking mechanism.

Although UNI holders have the power to activate the fee through a governance vote, many are afraid that doing so could substantially drop UNI’s dominance in the DEX market as LPs begin moving their liquidity elsewhere. 

“Liquidity providers’ main incentive to take on impermanent loss risk is the return on investment from trading fees, and these returns are already minimal,” Matt Fiebach, research analyst at Blockworks, said. 

“Suppose the protocol fee reduces returns to the point that they can no longer turn a profit. In that case, they will be forced to move liquidity elsewhere or stop providing automated market maker liquidity altogether. In this outcome, traders may receive better prices on other DEXs, causing Uniswap dominance to fall,” Fiebach said.

Read more: The Investor’s Guide to Impermanent Loss

The existing discussion prompted by community member Leighton Cusack, founder of DeFi protocol PoolTogether, suggests testing the fee switch with two of the most important pools on Uniswap: ETH/USDC and UDSC/USDT — drawing concerns from a handful of community members.

“I think using 2 of the largest and most important pools is pretty high risk,” John Palmer, Uniswap committee member, wrote in the discussion forum. “Personally, I would prefer to try something like this on a couple of smaller but significant pools to start before going this big.”

A decentralized exchange is only valuable if it has liquidity depth, and the risk of LPs moving holdings from Uniswap could be greater than the benefits. Proposals to experiment with smaller pools on the exchange are currently popular among many community members to reduce potential loss.

“I think it would be better to start out with less important pools [or] pools that provide relatively less utility to traders,” delegate MonetSupply wrote. “If LPs are put off by the protocol fees, they may be interested to move their liquidity to the lower fee tier pools which would provide improved utility to the Uniswap ecosystem.”

Uniswap currently is not strapped for cash, a community member going by BJP3333 wrote. “Taking fees away from LPs should be a last resort. Let’s explore other income-generating ideas first that don’t have this negative effect on the LPs,” he wrote.

As Uniswap is one of the biggest DeFi protocols, many competitors will likely be keeping an eye out on the decisions the organization ultimately makes.

Updated July 27, 2022, 5:00 pm ET — Correction: Uniswap’s community governance process will decide on the fee switch. A previous version of this article stated that Uniswap was discussing the fee switch. Uniswap does not participate in governance votes.

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