A Look at DeFi Yield Farming on Uniswap V2

Yield farming and liquidity pools on Uniswap V2.

There are quite a few seemingly strange words in the title of my first new blog post in ≈10 months. I will start with a few links to quickly lay out what they are : )

Jargon

To quote Coindesk: “Uniswap is a leading decentralised crypto exchange that runs on the Ethereum blockchain” (bolded emphasis mine). Uniswap is currently operating on the second version of their smart contract, and thus “Uniswap V2”. The short story here is that with Uniswap, anyone can be a market-maker (and/or taker) when it comes to the exchange (or “swapping”) of ERC20 cryptocurrency tokens, relying on smart contract code rather than a centralised exchange to execute such trades. This is part of the relatively new development of Decentralised Finance (DeFi).

Yield Farming” in DeFi is when you earn a % yield for your cryptocurrency tokens, e.g. where you commit your ERC20 tokens into Uniswap liquidity pools (LPs) to provide liquidity for others who may want to execute exchanges/trades/swaps between the ERC20 tokens. Each “swap” executed by others will attract a fee (fixed at 0.3% of the swapped value on Uniswap), which is awarded to liquidity providers as a yield. All these are done automatically by the smart contract.

Some Pre-Requisites

All operations on Uniswap are done via Ethereum blockchain’s smart contract transactions. There are some pre-requisites needed to provide liquidity:

  1. ERC20 token(s) to be added to Uniswap LPs
  2. Ether (ETH) to pay for Ethereum blockchain gas fees (smart contract transaction fees), and optionally to form the token pair with the ERC20 token above, if that is the token pair to be added to LPs.
  3. The two above need to be held within an Ethereum cryptocurrency wallet that is supported by the Uniswap interface (see screenshot below, as of the date of this post)

Checking Uniswap LP Info

As in traditional finance, it is prudent to check and confirm the info and details about DeFi operations you might want to make. In this case, the best place to start would be on Uniswap Info. It will show you the tokens with the most liquidity committed, and similarly the info for popular token pairs, including their volumes (how much has been exchanged/swapped) and thus the fees (0.3% of volume) attracted and distributed as yield to the liquidity providers.

Note that currently in the token pairs info table on Uniswap Info, the “1y Fees / Liquidity” column is extrapolated based on 24hr volume annualised, i.e. it is taking the “Fees (24hr)” column, multiplying it by 365 days, and dividing it by the “Liquidity” column to give a representation of % yield. This might not be a very good estimate due to the many assumptions implied, namely the “Fees (24hr)” —which is 0.3% × “Volume (24hrs)”— and the “Liquidity” staying constant for 365 days, which is quite unlikely to hold true. Arguably a better extrapolation would be to take the “Volume (7d)” column (i.e. volume in a week), multiplied by 52 weeks, then multiplied by 0.3% to get the estimated annual fees, and finally divided by “Liquidity” to get a different estimate for “1y Fees / Liquidity”, though note that this just uses a different set of assumptions!

Another more detailed check of the LP info would be to get the actual data points for the LP and crunch more numbers. The data can be found on The Graph Network’s Uniswap subgraph, which is also where Uniswap Info gets its data from, for all its tables and charts. (As an aside, The Graph Network seems to be another very exciting looking project in DeFi!)

A quick and dirty way of getting some useful data for the token pairs of interest would be to note down the smart contract address for the token pair, e.g. for UNI-ETH the link is https://info.uniswap.org/pair/0xd3d2e2692501a5c9ca623199d38826e513033a17 and thus the smart contract address (the pairAddress) is 0xd3d2e2692501a5c9ca623199d38826e513033a17. Then, in the Uniswap subgraph’s Playground, running the following query code will return some relevant past data for a maximum of 1000 daily data points, in JSON format.

{
    pairDayDatas(first: 1000, orderBy: date, orderDirection: desc, where: 
    { pairAddress: "0xd3d2e2692501a5c9ca623199d38826e513033a17" }) {
      date
      dailyVolumeToken0
      dailyVolumeToken1
      dailyVolumeUSD
      reserveUSD
    }
}

You can then feed this data into your own calculations, be it spreadsheets or data analysis code packages (e.g. in Python), and get different representations of % yield estimates. For example, % yield annualised from the past 30 days of data (or 60 days, or 90 days, etc.).

Contributing Liquidity to Uniswap LPs

If you decide that you actually want to contribute liquidity using your ERC20 token(s) and ETHs for yield farming on Uniswap, you can Google and find many how-to guides and articles about the steps, e.g. this one.

Note that the ERC20 token(s) and ETH need to be in the same Ethereum address. Then, using the Uniswap interface and your Ethereum wallet, you need to sign and broadcast two transactions:

  • The first one to give approval for the Uniswap V2 smart contract to operate on your ERC20 token(s);
  • the second one to actually commit and transfer the amount of token pair you want into the Uniswap LP.

These two transactions will require Ethereum gas fees, with the “approval” step taking ≈50k gas units, and the “commit liquidity” step taking ≈150k gas units. At current prices (for ETH and gas prices), these ≈200k gas units could cost >$30, possibly even up to ≈$100! This needs to be taken into account in your % yield estimate calculations, including the fact that there will be another two transactions needed in future to remove the liquidity you committed, so that you get back your token pair plus any yield earned.

Once you have successfully added your token pair into the Uniswap LP, if you append the Ethereum address that your token(s) and ETH were originally in, behind the Uniswap info address of https://info.uniswap.org/account/, you will be able to see more info about the liquidity that you added. For example, according to the recent transactions listed on the UNI-ETH token pair info page, some newly added UNI-ETH liquidity came from the address 0x26b7f43e5d1db167fc4b9cde1bc7fa16c84e729a, and so the link https://info.uniswap.org/account/0x26b7f43e5d1db167fc4b9cde1bc7fa16c84e729a will show info on that added liquidity, including the fees (denominated in USD) earned so far. The current exact quantities of the tokens (and ETH, if part of the token pair) are dependent on the current price ratio between the token pair, whereby changes in the price ratio will result in what is known as “divergent loss” (a.k.a. “impermanent loss”).

Divergent/Impermanent Loss

Google search will return many different useful posts and articles explaining divergent/impermanent loss in Uniswap. The short version is that if the current price ratio between the committed token pair is different from the price ratio at the point of the token pair being added into LP, there will be a current “paper loss” compared to if the tokens were just held and not added to the LP at all to begin with. It’s all mathematical in the pricing and swapping calculations in Uniswap, well described in the articles linked above, and defined in the smart contracts.

Divergent loss is not linear, and can be tricky. As a quick rule of thumb, any price ratio change of ×2 (or, symmetrically, ×0.5 for the inverse) will result in a divergent loss of ≈5.7%. However, note that if one of the tokens in the committed token pair experiences a huge reduction in price, it can result in near total losses for the liquidity provider, i.e. if the token pair price ratio goes to zero (equivalent to infinity for the inverse ratio), the total worth of the committed liquidity will go to zero! See the bottom left corner of the plot below, from Uniswap V2 docs:

Incidentally the near total loss described above is what happens in many DeFi scams, one of which is where a fake/shit coin that is not tradable on other exchanges (or only traded in tiny volumes elsewhere) is added to Uniswap as part of a token pair (e.g. with ETH), and then artificial volume on Uniswap is generated by wash trading of the token pair to create a temporary illusion of high fees/yield (showing up “top of the table” for 1y Fees/Liquidity on Uniswap Info), but when victims add significant amount of liquidity for this token pair to earn the high yield, the scammers swoop in with their huge holding of the fake/shit coin to swap and extract the ETH side of the token pair, leaving the victims holding a bag consisting solely of the actually worthless fake/shit coin.

In terms of earning yield (fees) while minimising divergent loss, token pairs that have a zig-zag or see-saw type of price ratio changes will likely provide the best returns, as the up-down-up-down changes in price ratio will attract swapping/exchange volumes from arbitrageurs, while getting minimal divergent loss since the price ratio is only swinging around a stable value. However, somewhat obvious to state, it is impossible to easily identify such token pairs! =P

Hopefully this is a useful look at DeFi yield farming on Uniswap V2.

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