Making Protocol Fees Operational

Thanks to @GFXlabs for the detailed post regarding the Uniswap Fee Switch. We share the excitement for expanding the design space for protocol-based revenue.

As many know, we have consistently advocated for ensuring the appropriate legal and technical structures are in place for the Uniswap protocol prior to turning on fees at the protocol level. Additionally, it’s important to consider the fee switch within Uniswap’s broader growth strategy. From a business perspective, what are the risks and rewards associated with the fee switch and LP behavior? Could turning on the fee switch now present an opportunity to a competitor DEX? Has the community designed a creative and elegant way to incorporate the UNI token into the economic structure of the network?

We believe patience is warranted due to these business, technical, and legal variables: (1) the overall risk-reward regarding Uniswap’s long-term business strategy, (2) the lack of programmable technical architecture for the flow of funds stemming from activating the fee switch (and the UNI token’s role in accessing such fees for performing work on behalf of the project), and/or (3) the need for a proper legal entity in the event fees pool at the protocol level.

Ultimately, if any action relating to the fee switch could result in a tax obligation, then there needs to be an ability to pay such obligation. Simply reserving funds is not sufficient. A legal entity could accomplish this and therefore greatly mitigate the risk associated with potential tax obligations for the Uniswap DAO. However, we recognize the legal and regulatory complexities associated with implementing an appropriate legal structure for the Uniswap DAO.

In the absence of a legal entity, it is important to reduce tax risk by using a programmatic flow of funds directly to token holders who are performing work on behalf of the DAO (as the Uniswap Foundation previously recommended here). A programmatic flow of funds could help ensure the taxable obligation rests with those users instead of the DAO.

Importantly though, the Uniswap v2 and v3 smart contracts are not explicitly designed for a programmatic flow of funds. They require governance participation to claim fees, whether from the FeeTo contract in v2 or a governance vote calling the collectProtocol function in v3.

The @GFXlabs’ proposal tries to address this limitation through their Fee Management solution “that allows anyone to pay the gas to collect the fees, sell the fee tokens automatically via the Uniswap auto-router, and then send the proceeds to the protocol treasury.” While we appreciate the innovative decentralized fee routing, it does not address the underlying issues regarding tax considerations for the DAO. In fact, it potentially exacerbates them.

@GFXlabs states they, “have separated the protocol fee discussion into two distinct conversations. One is the technical implementation of accruing fees in pools, collecting the accrued fees, and selling the accrued assets to a protocol-designated asset to be held in the treasury, and a separate conversation of how the assets in the treasury could be distributed, spent, or otherwise utilized.” This analysis fails to consider or appreciate the tax implications for such actions and is likely no better than just simply turning on the fee switch. Ultimately, any collection of fees at the protocol level without a new mechanism for the flow of funds could potentially result in a taxable event, one which the Uniswap DAO is not currently equipped to address. If you’re building a house, you don’t want to turn on the water until the plumbing is completely installed and checked.

The Uniswap Foundation alluded to the same line of logic in a follow-up post to the most recent fee switch discussion:

“Much of our research has led us to the conclusion that implementing a programmatic distribution of fees directly to persons, for instance to those who have “opted in” through taking some beneficial action for the Protocol, may be a superior path forward. This kind of mechanism would represent a significant mitigation of risk for the Uniswap DAO because tax obligations would rightfully be the responsibility of the individual in their respective jurisdiction, among other potential benefits. For instance, properly designed, this mechanism could further incentivize productive behavior to support the Protocol.

There have already been many comments in the forum exploring different uses of fees, including but not limited to: gas fee rebates, incentivizing LPs to lock their liquidity, and distribution directly to UNI token holders who actively “opt-in” through taking some beneficial action. Programmatic distribution of fees directly to stakeholders would relieve some, but not all, of the uncertainties associated with fees directly routing to the DAO.”

We understand the desire to turn on the Uniswap fee switch, but we think it’s necessary to take into consideration the nuanced factors in how it’s done. We are actively researching different methods and technical implementations that create a programmatic flow of funds to users and UNI holders who opt-in. We are preparing to provide an update next month on possible solutions. In the interim, while we appreciate GFX’s efforts here, we do not support this proposal and will vote against it based on the reasons above.

Porter, Miles, and Eddy - a16z