31 Jul 2023

Why we decided to exclude the UNI token from the KVQ Index

The Uniswap protocol generates significant trading fees, but will the UNI token ever capture its (fair) share? We believe not.
Uniswap cover picture SVG
UNI, the Uniswap DEX protocol token, is mainly a governance token. The current business model of Uniswap is a 0.3% fee on trades, where all fees currently go to liquidity providers. Both these parameters can be changed by governance votes to pay dividends to UNI holders. The supply is also fixed, and a majority vote would be needed to issue more UNI, much like shareholder voting in a company.
Uniswap key statistics SVG
Key statistics for the Uniswap protocol. July 31, 2023. Source: K33 Research
In a slow DeFi market, the fully diluted value of the UNI token is 15 times the annualized trading fees paid when using the protocol. If the UNI token captured all trading fees, the token would be a no-brainer buy. But this is not the case. The UNI token currently captures 0% of the 0.3% trading fee, which entirely goes to liquidity providers. On closer inspection, we find it highly unlikely that the UNI token can capture any significant portion of Uniswap trading fees in the future. The fight for trading fees can be stylized as a game of three players. Users (apps or people using Uniswap), the protocol (the UNI token gets potential rewards from this player), and the liquidity providers.Users care about two things: The cost and ease of trading. Liquidity providers care about securing the highest possible return on their assets. On expectation, this would be the product of trading volume and trading fees. The protocol doesn't have any strong beliefs in itself, but the UNI holders "owning" that exact copy of the protocol want to maximize the return on their UNI tokens.Let's start by considering the relationship between the protocol (UNI token) and liquidity providers. The Uniswap protocol is an open-source protocol imprinted on public blockchains. The implication of this is simple. The entire protocol can be exactly copied within minutes at virtually no cost. Liquidity providers, however, sit on presumably valuable holdings tokens.Now consider three exact copies of the Uniswap protocol on the Ethereum network. Which one would be the best for users? The answer is simple – the one with the most liquidity, as this would give the least slippage (best prices) when executing trades. So if users could costlessly aim at any of the exact protocol copies, they would always choose the best liquidity. This argument implies that all the power lies with the liquidity providers in the fight for trading fees.Switching to using another smart contract is not entirely costless, though, and there might be some stickiness. For instance, apps must update their code to point to other network addresses. However, given that you can exactly copy everything else except for the addresses, the switch should be quite easy (hence cheap). Given this relatively low cost of switching from the users' perspective, we cannot conclude with anything else than that the power lies with the liquidity providers. Hence, even though the Uniswap protocol generates significant trading fees, we believe the potential for the UNI token to capture any of this revenue to be almost non-existent.
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