"Fee Switch" Pilot Update & Vote

I’m struggling to get my head around this tax argument. What makes Uniswap protocol taking a share of fees different from pretty much every other defi protocol doing so?

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Hey everyone,

Miles and Porter here with a16z. Thanks to @Leighton and @guil-lambert for their proactive stance on the fee switch discussions. From our perspective, the risks associated with turning on the fee switch generally fall into three brackets and could be addressed as follows:

  • Risks Associated with Commissions - Generally, there are regulatory risks associated with taking commissions on the trading of assets, though as indicated in the Uniswap Foundation’s post, most of these can likely be addressed by limiting commissions to trading pairs with an unambiguous status as not a security.

  • Risks Associated with UNI Token - The protocol accruing profits from trading also impacts the analysis as to whether any transactions of UNI tokens could be deemed to be transactions involving investment contracts requiring the application of U.S. securities laws. However, given the significant decentralization of the Uniswap protocol, we do not believe it would be reasonable for anyone to be dependent on the managerial or entrepreneurial efforts of any party associated with the Uniswap protocol. Further, if profits are not directly distributed to UNI token holders, the complications and impact of such a proposal could be greatly reduced.

  • Risks Associated with Organizational Structure - If the fee switch is turned on, then the DAO could have control over accruing profits, which could have implications for tax purposes. We believe a very narrowly tailored legal entity structure (relating only to the profits accrual and use of those funds) could potentially be used to enable the DAO to pay any required tax obligations and could provide DAO members with limited liability protections. The additional goals of any such structure would be to maximize flexibility of the DAO, enable UNI members to opt out from participation in such structure, limit the impact of the structure on the DAO’s broader activities and regulatory positioning, and preserve the ability of the DAO to dissolve such structure if an alternative approach became available.

We’re actively working to assess the above risks as well as a potential entity structure that meets the organizational requirements, and we’re interested in hearing other perspectives and proposed solutions for the risks identified above.

However, for this specific discussion, we ultimately cannot support (and will vote against) any proposal that fails to account for these factors. While we appreciate the efforts to drive the fee switch forward and believe this proposal solves the first two issues, in its current form it does not address the third one - an organizational structure for tax purposes.

Even though the proposal is labeled as a “test run only” it would set in motion potential organizational and tax issues. We believe the risk from the proposal outweighs the potential benefits. We are evaluating a plan that will address each element (including the organizational issue), but that process will continue to take time. As that analysis continues, we think patience is warranted to get the full legal and regulatory analysis correct before proceeding further. In light of all that has happened in the web3 sector this year, we believe it is fundamentally necessary for Uniswap DAO to lead the industry on a pathway that shows that DeFi can exist and operate in a legally compliant manner.

On a final note, one other way to potentially avoid many of the risks associated with the fee switch would be to implement a system that accrues fees to UNI token holders who actively “opt-in.” In this scenario, LPs would stake UNI and their LP tokens to receive boosted rewards from the liquidity pools in which they are providing liquidity. This has the added benefit of incentivizing liquidity providing and directly rewarding the parties that actively participate to keep Uniswap running. We recognize there are a number of technical hurdles prior to implementation, including fee claiming, fee management, and multi-chain fee switches, but we think this option should be explored further in parallel to the general fee switch discussion.

We can be reached here on the forums or on Twitter for those with additional questions!

Best,

Miles and Porter

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Hi Uniswap Community,
Almanak is a web3 simulation platform that enhances decision makers with risk management tooling across DAOs. We have been following the discussion around the fee switch & its testing since the very beginning (thank you @guil-lambert for your efforts) and would like to drop additional comments regarding our most recent observations.

TL;DR

  • We suggest the fee switch test be run with specific metrics to avoid any duality/wrong facts being stated during or after the trial.
  • The current KPI (“trade execution not diminished”) may not fully grasp important levers of the fee switch mechanism. A larger set of metrics, covering trade volume, net liquidity & market share, would allow for a more exhaustive assessment.
  • As a follow-up step, we suggest to consider ** a benchmarking & validation process for the test to further evaluate the sustainability of the fee switch**, regardless of the macro-economic environment, and assure the best possible basis for decision-making.

Discussion

We would like to suggest a set of meaningful metrics to interpret the results of the fee switch implementation in a correct and digestible way:

  • Trading execution (slippage + fees) is a relevant and important metric, yet does not reflect the impact on the pools and the protocol
    Optimal trading execution is one of the key topics for a majority of trades on DEXes driven by MEV bots and market makers. Both use pools with high liquidity to limit the impact of slippage on their profit margin. Offering the best execution price and highest return will loom more volume to the pools. Yet trading execution is not a tangible metric to track as it only tells the story of executed trades rather than the ones that were not, which equals to lost volume.

  • Tracking pool and market share combined with liquidity flows could be top-line metrics to implement to understand the impact more clearly, supported by bottom-line dimensions such as liquidity retention and shifts
    We agree with the general direction @msilb7 highlighted: not only should the pool volume of each pool tier be reflected but additionally the overall Uniswap v3 market share of the trading pairs. We suggest further refining what specific metrics to use and their respective units. The metric set will highlight the impact of liquidity not being available on the respective Uniswap pools but on other DEXes, which then aggregates more trades and a higher market share. Note that the metrics would have the following units:

    • Pool volume/comparison: MM$, compared against other Uniswap v3 pools of the same token pair prior, and post fee switch.
    • Uniswap Market share of trading pair: %, compared against all other decentralised exchanges offering the trading pair prior, and post fee switch.
    • Net liquidity flow: MM$, difference in liquidity being transferred from and to other DEXes or other venues to and from Uniswap v3 pool undergoing the fee switch experiment.
    • Liquidity shifts: MM$, liquidity being transferred onto other Uniswap v3 pools of the same token pair prior, and post fee switch.
    • Liquidity retention: Median tenure of liquidity position in hours, monitoring the stickiness of liquidity providers of different pools.
  • Benchmarking/Validating the fee switch approach is currently not tackled
    Even though the Uniswap community opted to trial the fee switch on live pools, we support the idea of shedding light on the “what if?” question. Comparing the different notions of challenging macroeconomic environments is not trivial and validating how a fee switch will fare with different constraints is in the community’s interest to not only rely on this test on selected pools. Ongoing research led by the Uniswap community can help to define volume and liquidity capacities to be simulated. The overarching environment can be populated by trained agents on these specific metrics, executing actions when the simulation is running. Actions will either result in trades, deposits of liquidity or respective withdrawals as well as interacting with other exchanges to represent the competitive environment…

Suggestions

  • We propose to use the above group of metrics to be tracked along the experiment for a clear communication and alignment of goals across the community. The variety of metrics covers both the impact of external factors (missing volume on Uniswap transferred to other DEXes) and internal observations (where did liquidity flow). We additionally add the respective units and specifically define what to track and what not to.

  • Introduction of Benchmarking/Validating framework in additional to tracking/testing of the fee switch to validate the current fee switch implementation in simulation environment. This environment represents an additional layer of validation whether or not to implement the fee switch.**

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Thanks @Porter.

It would be great to have more clarity on your timeline for “evaluating a plan that will address each element.”

This is my first post on the governance forum, so hello Uniswap community :smiley: . There is a massive gorilla in the room which has not yet been mentioned on this thread, the business license of the v3 core contracts expires on April 1st 2023, which is less than 120 days from today. If the proposal to test the fee switch for 120 days were to pass 8 days from now when the voting happens, ~100 of the test days would be with the BUSL active, and ~20 days of fully open source v3 core.
My proposal is to set the start date of the 120 day test to be January 31st 2023. This test would have 60 days with no other range liquidity alternatives for LP’s to migrate to, and then 60 days with v3 core fully open sourced where there may be a competitive fork that draws LP’s.

Can you please explain what you mean by “actively opt-in”?

Are you referring to LPs going through some sort of KYC process?

I think incentivizing LP’s by having to opt in through staking UNI is perhaps not the right direction.

Here is a thought on organization structure:

What if the collected fee’s from the fee switch are claimed by the users who are trading on Uniswap as a gas fee rebate? For example, User A makes a swap, it costs that user 3 dollars in gas. In the act of the swap, a small % of the accumulated (fee switch) fee’s is claimed/directed to the gas fee’s of the swap transaction (and it doesnt have to be 100% of the gas cost, can be 30% etc of the cost for more users). Better yet, if the claimed fee’s were auto swaped into UNI token in the process of rebating to the user. It further decentralises UNI distribution to the user’s of Uniswap.

This organizational structure would not see the protocol gaining revenues (more so of a community pool) since the fee’s would be used as a cost rebate to the user (the user is opting in to paying the tax on the gas rebate vs the protocol)?

This alternative use for the fee switch designates it as a public good to the user’s of the protocol, and benefits LP’s through increased user acqusition/volume.

Hey @will_leas - late January or early February.

Pains me to say it but Avantgarde will be voting No on this iteration.

While I appreciate the decoupling of the “does this change the product” question from the “what are we going to do with the fees” question, I think it’s impossible and ultimately irresponsible to ignore the other potential negative externalities in the name of experimentation.

Ultimately, turning on the fee switch will bring the protocol into the regulatory crosshairs and to do so without a plan for how we’ll answer when the various authorities come around asking questions is folly. Both @Porter’s post and the UF brief touch briefly on potential vectors of liability for various stakeholders and both indicate that work is ongoing to mitigate those liabilities. Let’s wait for the output of that work before moving forward.

This conversation - while it may not actually result in these fees getting turned on this time - has been super valuable in galvanizing the community around the idea that the fee switch should be turned on in some form or fashion. Kudos to @Leighton for getting it started and for the various people and teams who have gone deep into the data to figure out where this experiment should take place.

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interesting idea :slight_smile:

When you say opt-in, is there a reason why the example idea only mentions LPs opting in? Do you not see this being available to any UNI holder that doesn’t provide liquidity?

Think that a DAO-linked legal entity to achieve tax compliance (first) and eventually registration is the way forward to enable DeFi as a real alternative market infrastructure and draw a line vs the CeFi mess.

Very interested in your work here for Uniswap and other protocols. If the timeline is Jan-Feb, probably worth to delay the vote again.

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It could be available broadly, that example just intended to show there could be boosted rewards for those that do both.

Alana and Derek here with Variant. We’ve been following the fee switch discussion over the past few months, and wanted to provide an update on our perspective.

First, we’re still strongly intellectually aligned with the proposal: we think experimentation with protocol parameters, such as the fee switch, is good and needed. We commend @Leighton for putting forward the initial proposal and spurring what we consider to be a very productive discussion. We also appreciate that Leighton and @guil-lambert incorporated our feedback on potential testing pools in the final proposal. As previously mentioned, in the long run we believe the fee switch can not only drive fundamental value to the UNI token, but also be used as growth capital for the protocol to secure its position as the leading DEX in web3.

We also recognize that a number of valid legal and regulatory considerations have been raised throughout this process. Our view is that the best way to drive progress on these issues is to move forward with the proposed experimentation. Action begets action. These considerations were only raised because there was an initiative to push forward with the fee switch. Thus, we believe that approval of the fee switch experimentation will similarly catalyze deeper engagement on tax, legal, and other regulatory issues from Uniswap stakeholders. Delaying action, on the other hand, risks an endless cycle of further postponements.

Framed another way: high-growth projects often succeed by shipping and experimenting. This proposal embodies one way that Uniswap can continue to “ship”, which we believe is necessary for the protocol to continue innovating and to maintain its leading market position. As a result, we’re supportive of moving forward with the proposed fee switch experimentation.

Finally, to be clear, we agree that the tax and regulatory considerations raised by a16z and others are important. Specifically, we are aligned that the community needs to ultimately find and implement solutions to tax compliance, and will benefit from greater clarity on both legal entities for tax obligations as well as liabilities as they relate to token holders, regardless of whether the fee switch proposal is approved. As @devinwalsh mentioned, the Uniswap Foundation has already begun to engage the community on this front and we see an opportunity for further work that advances to actionable, open source implementation details for the community to act upon.

This post was authored by Alana Levin and Derek Walkush, investment partners at Variant. Variant is an investor in the UNI token. See disclosures.

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One potential approach to avoid tax issues with the fees collected by the feeswitch is to burn the fees. By burning the fees, we can ensure that the fees are not subject to taxation, as they would no longer exist and therefore could not be considered taxable income for the purpose of this pilot. An alternative approach to avoid tax issues would be to donate funds accrued to a tax-exempt charity recognized by the IRS. This would allow the funds to be put to a better purpose and may potentially provide tax benefits.

This approach could provide a way for the Uniswap community to maintain the integrity and decentralization of the platform, while also addressing the optics of potential tax implications into launching a feeswitch “experiment”. However, it is important to note that the above approaches may also have drawbacks and limitations, and it should be carefully considered before being implemented.

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We are very thankful for the robust discussion that has happened over the past two weeks. Although @guil-lambert and I have not responded to every comment, we have read them!

In the responses, two general positions have emerged. The first position has been best articulated by @alanalevin. This position acknowledges there are potential regulatory risks with the proposal but ultimately advocates moving forward now. Recognizing some uncertainty will never be settled and “action begets action”.

The alternative position advocated by @Porter and others is to further de-risk some specific regulatory issues before moving forward. The most prominent of these being the concern some delegates have that fees generated could be considered taxable income.

Outside of these regulatory concerns, @Jack_Longarzo also did a good job articulating some of the broader risks any misstep could have on the largest DeFi protocol. We believe this is a very important point.

Similarly to previous discussions, the simple posting and planning for the vote also generated a high level of engagement from new and existing stakeholders which we are very happy to see.

In reading the feedback and having conversations over the last 2 weeks our view is that this proposal can be meaningfully de-risked in a short amount time. That can happen by putting in place a legal entity structure to alleviate concerns some delegates have around potential tax implications for the pilot. Our understanding from talking to stakeholders is there will be a thoughtful proposal on options to create an entity to handle this in a few weeks. From there, an option can be chosen and proposal can proceed with that aspect de-risked and we will put forward a vote!

That will enable us to move forward with the pilot in a unified way. We also believe this will set a much stronger foundation so that if the pilot is successful, there can be a path to transition from a pilot to larger implementation aligned with protocol growth (see @Porter last paragraph for one possible way that could look).

We know additional waiting will be painful to many but we truly believe for the good of Uniswap and DeFi as a whole it is crucial for us to set the best possible example.

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Difficult to convice LP, if it’s not clear how will these retained fee be utilize.

It’s wouldn’t work if you just take my money away, and nothing promised. Leave room for corruption and suspicious.

Suggest, first, to be more clearer on how the retained fee will be used.

One of the big question marks of the Fee Switch is market share impact. Eventually, it comes down to users attrition, or viewed from the opposite stance: Stickiness.

And because of the occurrence of triangular inter-pool trading within Uniswap pools, measuring and understanding stickiness is challenging.

Even though we could still imply it from the other pools (used for triangular spillovers) change in activity post-switch vs historical levels, it’s difficult to disentangle what share of that activity would be resulting from which pool among the three activated pools.

Stickiness (of trading and liquidity) is very pool-specific.

From our analysis ETH-DAI 0.05% and ETH-USDC 1% would not be too impacted by this side effect. The former a bit more than the latter due to whale behaviour.

However ETH-USDT 0.3% seems more prone, with JIT playing a role on liquidity and Curve on trading volume.

Overall outcome is clearly agent-driven so the experimentation will benefit from incorporating behavioural analysis through simulation.

Read our full analysis on our Medium post

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Unfortunate to see this being deferred to yet another vote. @Leighton writes:

“Our understanding from talking to stakeholders is there will be a thoughtful proposal on options to create an entity to handle this in a few weeks. From there, an option can be chosen and proposal can proceed with that aspect de-risked and we will put forward a vote!”

Any update on the entity creation? Can anyone create a proposal for entity creation? If so, I will be more than happy to do this.

The UF is working on an update here and should have a post with more details over the next few days!

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Providing an update here. As @Leighton wrote back in December, the vote on the fee switch proposal would be delayed for a short period of time in order for some uncertainties to be addressed. Specifically, he cited community feedback to “[put] in place a legal entity structure to alleviate concerns some delegates have around potential tax implications for the pilot”.

Since then, the UF has been working with a set of advisors to put together a proposal which aims to address that uncertainty. To do that, we identified the requirements for an entity type for the DAO, assessed several entity types against that criteria, and selected an entity type which we believe will best serve the DAO’s needs. Right now, we are in the process of finalizing our proposal. This finalization will entail more detailed analyses of all known implications of our proposal for the DAO, as well as finalizing a process for implementation. That implementation process will, among other steps, entail time for community discussion as well as Q&A.

We are working out these details and hope to have the proposal posted on the forum in ~2-3 weeks.

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