$UNI — The Valueless Token of the Most Valuable Protocol

Uniswap is the most profitable protocol with its 7-day average fees income even surpassed Ethereum recently. Uniswap is also unique in that it distributes all trading fees to liquidity providers. Its governance token $UNI barely accrues any value from the extreme success of the protocol. Should Uniswap turn on the famous “Fee Switch” function, the topic has been discussed to death in the forum. What are the considerations? As a $UNI holder, what should you expect?

A Fee Generating Machine for Liquidity Providers

As a decentralized exchange, the protocol charges a transaction fee for every swapping transaction through the platform. In v2, the swapping fee is 0.3% on the transaction amount for all pools, while in v3 the swapping fee ranges from 0.01% to 1% for different liquidity pairs.

Being the largest decentralized exchange, the protocol is literally a fee-generating machine, the 7 days average fee has repeatedly surpassed what Ethereum generated!

Source: https://cryptofees.info/

The uniqueness of Uniswap is that it directs all its fees to the liquidity provider, resulting in the protocol itself and $UNI token holders not being rewarded directly from the trading activity that occurs in the protocol.

To give some context, Curve Finance distributes 50% of the fees it collected to liquidity providers and the remaining 50% is distributed to veCRV holders. (Related reading: Curve Finance — DEX Designed for Stablecoins) For Sushiswap, the transaction fee is set at 0.3%, in which 0.25% goes to liquidity providers and 0.05% goes to xSushi stakers. In one way or another, token holders of those protocols get some benefits when people use these protocols to trade.

…but a Value Vacuum for $UNI Holders

Since every dollar the Uniswap collected is distributed to LPs, the protocol has zero revenue, and so as the token holders. $UNI is a pure governance token that is used for voting on any changes to the Uniswap protocol. We could argue that governance power has its value since $UNI holders could potentially vote to take a cut from the transaction fee to the protocol and distribute this revenue to token holders. Here comes the famous “Fee Switch” debate.

The Fee Switch

Since the release of Uniswap v2, a fee charge switch is included in the code so that the protocol has the ability to take a cut from the fee collected if the governance approves.

In v2, the transaction fee rate is set to a fixed value of 0.3%, with a fixed 0.05% of the 0.3% being allocated to the protocol if the fee switch is turned on.

The protocol will decide how to use this new revenue stream through governance proposals. It is possible to distribute the revenue to $UNI holders or to use it for any other purpose, such as saving it in Uniswap vault for future development expenses. It is important to note that turning on the fee switch will only help the protocol collect a portion of the transaction fees, it does not necessarily mean that the fees will be allocated to the $UNI holder. When the fee switch is turned on, the $UNI holder will still need to initiate governance proposals to determine the distribution of this revenue.

In Uniswap v3, the liquidity pool creator can set the transaction fee rate and choose whether to turn on the fee switch on a per pool basis. If the fee switch is turned on, the minimum setting is 10% of the transaction fee. For example, if a liquidity pool with a 0.05% transaction fee rate is set at 10% of the protocol-take-rate, each trade made on that liquidity pool will generate 0.005% of Uniswap’s revenue.

Should the Fee Switch Be Turned on?

The analysis is to decide what is the impact on different stakeholders of Uniswap if the fee switch is turned on. We could divide the stakeholders of Uniswap into 3 groups: $UNI holders, Liquidity Providers, and Traders.

  • $UNI holders

For $UNI holders, this could be the most significant catalyst. No matter it is a buyback and burns mechanism or direct distribution are all beneficial to token holders. Even if the final decision is to keep the revenue in the treasury, it will demonstrate a willingness of the community to move forward and will give $UNI holders some kind of hope that they could vote for the distribution in the future.

Investors shall closely monitor the development of this issue, if there were any sign that the community is likely to pass a proposal that could lead to the switch to be turned, it would definitely push up the token price.

  • Liquidity Providers

A liquidity provider is in the business of providing liquidity to liquidity pools for fees and assuming the risk of impermanent loss. The $UNI holder’s gain is actually the LP’s loss. Now that LPs receive 100% of the fees collected through transaction fees, turning on the fee switch means they need to give up at least 10% of their revenue, which must affect LP profitability. the reduction in LP revenue will inevitably affect their decision-making. In the worst case, LPs now on Uniswap will choose other DEXs to provide liquidity, which in turn will lead to a loss of liquidity from Uniswap.

  • Traders

For traders, it is simple. There is no impact at all. They pay the same transaction fee without any changes.

However, if we consider the entangled relationship between LPs, Traders, and $UNI holders, we will realize it is actually much more complicated. If some LPs remove their liquidity from the pool due to the lower profitability, this may result in higher slippage for trading and thus impact the trading experience. If traders choose not to use Uniswap due to the higher slippage, this will in turn reduce the transaction volume of the protocol, thus leading to a lower transaction fee revenue.

Furthermore, there is also the concern with regulation. If the protocol start to distribute fee income to $UNI holders or conduct some kind of buyback and burn mechanism, it will make the token much more like a traditional security. And if $UNI is deemed as a security by U.S. regulators, it will bring serious trouble to both $UNI holders and the protocol.

Surely, many other protocols have an income distribution mechanism and have not incurred any regulatory trouble. But being the most well-known DEX, this is a risk that cannot be ignored. Since there is no formal regulation for DeFi or tokens around the world, it really depends on how a specific regulator thinks about this issue. (Related reading: Crypto Regulation 101)

Whether to turn on the fee switch has been a continuous discussion for over 1 year in the Uniswap forum, and as you can see, due to the complexity of the issue, it seems to become a never-ending discussion without any action.

How Do DAOs Make Tough Decisions

In business, there is no decision that will be 100% successful. Every decision has its advantages and disadvantages. Detailed analysis helps to provide a comprehensive understanding of all the factors involved in making a business decision. But ultimately, someone needs to make a judgment call and take responsibility for it and its consequences.

In a traditional business model, the CEO makes the final decisions. But for a DAO, the final decision is made by a vote of the governance token holders. This governance model can easily make any tough business decision a never-ending bargain between different stakeholders.

Closing Thoughts

The fee switch looks like an economic issue on the surface, but it is essentially a governance issue. The current governance framework is not able to make bold and controversial decisions. There is an in-depth analysis regarding this, “The State of Uniswap Governance: A Paradox of Minimization”. What’s more, the resolution to move forward with the Uniswap fee switch is likely to evolve into a change in the decentralized governance model.

The original post can be found here at Tokeninsight.

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