TLDR: Only turn on the protocol fee when LPs are consistently earning enough to absorb the 10-25% cut. For v2/v3, the fee switch may be defensible as a migration tool toward v4. But applying it to v4 without compensating LPs, for example with sustained UNI incentives to boost revenues/implied volatility, risks killing the LP base and the protocol.
Disclosure: I am the founder of Panoptic, an options protocol built on top of Uniswap v3/v4 and I voted “Abstain” on the UNIfication proposal.
Turning on the fee switch may make sense as a way to deprecate v2+v3 in favor of v4. If you take a full 25% cut of all LP revenue for all v2+v3 pools, it will drive away LPs to v4.
But turning on the fee switch for v4 pools as well means there will be nowhere for the LPs to go except to other AMMs/UniV3-forks.
Turning on the v4 fee switch risks killing the protocol.
It favors short-term interests of token holders at the detriment of real stakeholders (LPs) who ultimately are the ones keeping the protocol alive.
What is LPing?
Every liquidity provider is structurally short convexity: the value of a LP position follows a ~√price for Uniswap v2 and a covered-call-like payoff for Uniswap v3
Any short convexity position is structurally underperforming simply holding the assets: as the price moves up or down, it earns less than a strategy that consists of linear holding positions --eg. the dreaded impermanent loss.
How to make LPs profitable?
The inherent structural imbalance of convex positions has to be matched with an external cash flow.
In TradFi, a convex position like a covered call will receive an upfront payment when created. The tradeoff is that a covered call seller gives up unlimited upside in exchange for a small upfront compensation. If that compensation is not high enough, covered call sellers are structurally in a -EV position.
In Uniswap, that fee is not paid upfront but is streaming to the LP position holder over time. But that fee stream acts as a compensation for giving up future (and potentially unlimited) gains due to holding that short convexity position.
Pay LPs a high enough fee, their position will be +EV. This is what we saw during DeFi summer: stake your LP tokens, earn 1000% apr in tokens! Those extra tokens were a way to bootstrap liquidity by pumping the fees received by LPs.
How to price convex positions
In TradFi, going back to the covered call example, the premium paid upfront is actually under the control of the seller: they must find a suitable buyer for the call they just sold, and unless they can agree on a fair price for that option, then the transaction won’t happen.
How do you fairly price an option? There are several models available (with the Black-Scholes model being the most successful one), but all pricing comes down to a single number: the implied volatility (IV).
Both parties, the seller and the buyer, will be satisfied with their trade once they agree on the IV of that position. If IV is too low, buyers are structurally +EV, if IV is too high, sellers are +EV.
How much fee revenue is enough
Since a call seller is giving up unlimited upside while retaining downside exposure, they MUST receive a higher compensation to make them statistically +EV to account for the edge case where they lose their entire investment (or more).
This means the implied volatility of an option is very often higher than the realized volatility (RV) of that asset. Otherwise, the option buyer will underpay for that privilege to be exposed to unlimited gains and a limited loss.
Volatilities in Uniswap v4
Are LPs currently compensated enough on Uniswap v3 and v4?
We can compute the implied volatility of LP positions in Uniswap by looking at the daily volume, the average at-tick liquidity, and the amount of fees collected. The realized volatility can also be computed from the actual block-by-block price move.
Here’s what the implied vs. realized volatility looks like for the ETH-USDC-30bps pool on Uniswap v4
Most of the time, the realized volatility (blue) is above the implied volatility (purple). The brief amount of time IV > RV was in early June when the price of ETH went down to 1550 and hit low liquidity zones.
There are several reasons why the realized volatility is above the implied volatility. In TradFi, this means the market has low entropy/quality flow. On Uniswap, trades being mostly arbitrage is one reason. Routing +EV trades through UniswapX instead of through the underlying Uniswap pools is another.
Volatilities in Uniswap v3
In Uniswap v3, the fee switch means that LPs receive 10-25% less fees than the same position on Uniswap v4. Since the fee paid by buyers is still 5bps, 30bps, or 100bps, the flow and realized volatility will remain the same, whereas the implied volatility will be based on fee revenues that are 10-25% smaller, basically shifting the whole IV curve down by 10-25%.
We can clearly see this for the WETH-USDC-5bps pool on Uniswap v3. Here, the implied volatility is computed using that 25% fee switch, meaning that each swap earns the LPs 3.75bps instead of 5bps.
source: https://app.panoptic.xyz/pool/ethereum/0x88e6a0c2ddd26feeb64f039a2c41296fcb3f5640
The implied volatility is never above the realized volatility
Even during that transitory period when the pool had lower liquidity in early June, the net returns for LPs were not high enough to compensate for the potential losses they were just subjected to.
Some pools do have a IV > RV relationship (eg. the LIT-USDC pool, memecoins, and basically most pools pre-2023) because they have/had organic activity.
Proposed Solution
I am not saying to never turn on the fee switch.
But the protocol fee should be conditional on LP profitability. If a pool’s implied volatility is consistently above realized volatility, then governance can take a cut without breaking the LP trade.
Instead, if RV > IV, then LPs are already undercompensated. Taking 25% of their fees does not monetize the protocol. It pushes LPs further into negative EV.
For v2 and v3, a fee switch can make sense as a migration tool to deprecate legacy pools and push liquidity to v4. It remains to be seen whether v4 can truly give LPs a better venue with hooks, dynamic fees, and better execution design, but at least the vanilla v4 pools have a better RV-IV profile.
But if you add a 25% pay cut on top of a structurally inefficient market, the only rational move for LPs is to leave the Uniswap ecosystem entirely.
The only way I see myself supporting this is if LPs are directly compensated with $UNI tokens or through other means that make LPs consistently profitable. And I don’t mean $100k in incentives sprinkled over months here: it has to be millions and sustained practically forever until organic activity returns.