Backtesting framework for concentrated liquidity market makers on Uniswap V3 decentralized exchange

Abstract

Decentralized Finance (DeFi) has revolutionized the financial landscape, with protocols like Uniswap offering innovative automated market-making mechanisms. This article explores the development of a backtesting framework specifically tailored for Concentrated Liquidity Market Makers (CLMMs). The focus is on leveraging the liquidity distribution approximated using a parametric model to estimate the rewards within liquidity pools. The article details the design, implementation, and insights derived from this novel approach to backtesting within the context of Uniswap V3. The developed backtester was successfully utilized to assess reward levels across several pools using historical data from 2023 (pools Uniswap V3 for pairs of altcoins, stablecoins, and USDC/ETH with different fee levels). Moreover, the error in modeling the level of rewards for the period under review for each pool was less than 1%. This demonstrated the effectiveness of the backtester in quantifying liquidity pool rewards and its potential in estimating revenues of Liquidity Provider (LP) as part of the pool rewards, which is the focus of our next research. The backtester serves as a tool to simulate trading strategies and liquidity provision scenarios, providing a quantitative assessment of potential returns for LPs. By incorporating statistical tools to mirror CLMM pool liquidity dynamics, this framework can be further leveraged for strategy enhancement and risk evaluation for LPs operating within decentralized exchanges.