What is a Fee Switch?

A fee switch is a mechanism in DeFi protocols that controls the fee allocation. By activating the fee switch, a portion or all of the fees generated by the protocol can be redirected from liquidity providers (LPs) to governance token holders, stakers, or the protocol’s vault. The fee switch is a tool for protocols to optimize their economic models, enhancing governance token value capture and boosting profitability.

Every transaction incurs a fee in most decentralized exchange (DEX) protocols, such as Uniswap. This fee is usually allocated directly to liquidity providers (LPs) to incentivize them to continue providing liquidity. For example, in Uniswap V3, the default fee per transaction is 0.3%, and all of it goes to the LPs. However, protocols often include the option to enable a fee switch, which, through smart contracts, can redirect a portion of the transaction fee (e.g., 0.05%) to governance token holders or the protocol’s vault.

When the fee switch is off, LPs receive the full fee. However, when the fee switch is on, a portion of the fee is directed to governance token holders or stakers.

The core design of the fee switch revolves around fee income redistribution. There are several models for how this can be done:

• Fixed Split Model: For example, 0.25% of each transaction could go to LPs, while 0.05% is allocated to governance token stakers.
• Dynamic Adjustment Model: In times of low liquidity, the LP share could be increased, whereas, during periods of high liquidity, more rewards could go to governance token holders.
• Multi-Channel Distribution Model: A portion of the revenue could go to the protocol’s vault, for ecosystem development or risk reserves.

The fee switch can be triggered in various ways, such as through community governance decisions or automated mechanisms based on specific conditions (e.g., when the protocol’s income reaches a certain threshold).

Fee switches operate in two main modes: Partial Activation, where only a portion of fees is redirected to stakers or the protocol’s vault, and Full Activation, where all fees are redirected from LPs to token holders or stakers. Fee Conversion refers to the process of converting the protocol’s revenue from native tokens into governance tokens (such as UNI and BLUR), which are then redistributed to stakers or token holders.

This article will further explain the significance of fee switches for DeFi design by exploring the different designs and impacts of fee switches across protocols.

Uniswap’s Fee Switch Controversy

Uniswap, one of the most influential DEX platforms globally, was founded by Hayden Adams in 2018 and operates on the Ethereum network. Known for its efficient trading mechanisms, open liquidity provision rules, and community governance, Uniswap has consistently led the DEX space regarding trading volume and user activity. At certain times, Uniswap’s trading volume even exceeded that of some mainstream centralized exchanges. A common challenge for many DeFi protocols is the limited value capture of governance tokens. To solve this, the community proposed the idea of a fee switch.

On December 2, 2022, Leighton, co-founder of PoolTogether, posted a proposal titled “Fee Switch Pilot Update and Voting” on the Uniswap governance forum. This proposal, co-written with Guillaume Lambert, the founder of Panoptic and Assistant Professor at Cornell University, aimed to assess the impact of activating the fee switch on selected Uniswap protocol pools through a pilot program.

The fee switch has been a key point of discussion for Uniswap, mainly centered around redistributing protocol revenue. While Uniswap currently directs all transaction fees to LPs, activating the fee switch would redirect a portion of those fees to UNI token holders or the protocol’s vault, boosting the governance token’s value capture.

However, activating the fee switch could affect LP returns, potentially impacting liquidity depth and trading efficiency, which is why the community has approached the discussion cautiously. This proposal aims to test the fee switch’s impact through a small-scale, short-term pilot, to provide data-driven insights for future governance decisions.

Proposal Content

The experiment will pilot the fee switch with the lowest setting (1/10) for the following trading pairs over a period of 120 days:

• ETH-USDT-0.05%
• DAI-ETH-0.3%
• USDC-ETH-1%

Success Criteria: The pilot will be considered successful if the trading execution in the pools with the fee switch enabled is unaffected.

During the pilot, the fee switch will be tested with the minimum setting, meaning that 1/10 of the fee will be allocated to the protocol’s vault. For example, if the default fee is 0.3%, 0.03% will be redistributed, while the remaining portion will still go to LPs.

Community Concerns

The proposal has attracted considerable attention, and concerns about its long-term impact exist. Some LPs believe allocating 1/10 of the fee income to the protocol vault, though a small proportion, could still lead to a decrease in overall LP returns. Given the fierce competition in the DeFi space, lower returns could lead LPs to shift their liquidity to other protocols, potentially reducing Uniswap’s liquidity depth.

Currently, Uniswap doesn’t offer additional incentives to offset the reduced LP rewards from activating the fee switch. This may lead LPs to withdraw their liquidity, thus weakening Uniswap’s competitive edge. If LP returns consistently fall below those of competing protocols like Balancer or Curve, Uniswap could struggle in the liquidity race. Some members have proposed that the protocol vault provide extra rewards to LPs or adjust the fee distribution ratio dynamically to mitigate the negative impact on LP returns.

Additionally, questions were raised regarding the success criteria of “no impact on trade execution.” The proposal’s definition is unclear and requires clarification on whether it pertains to slippage, trading fee fluctuations, speed, or confirmation times. Some members suggested using slippage and pool depth as key metrics, alongside user feedback, to assess trading performance. The community also recommended leveraging smart contract monitoring tools to track pilot pool performance automatically and regularly release data to ensure transparency.

Regarding tax and regulatory concerns, some UNI token holders worried that fee redistribution could create tax complexities, as rewards could be taxable income, increasing their financial burden. In response, the Uniswap Foundation issued a legal briefing to guide the community on how to handle fee income compliantly.

Final Result

During the voting period, a clear division of interests emerged: UNI token holders sought to strengthen the governance token’s value, while LPs were concerned that reduced returns would undermine their incentives to provide liquidity. The proposal failed to gain enough support and was ultimately rejected.

Community feedback was mixed, with some calling for further optimization, while others noted that balancing governance token value capture with liquidity incentives remains a central challenge in DeFi protocol governance. Achieving this balance will remain a key issue in future protocol governance.

Blur’s Fee Switch Proposal

Launched in October 2022, Blur is a decentralized NFT marketplace and aggregation platform. It allows users to view and bulk-purchase NFTs across multiple marketplaces and provides a fast and efficient trading experience through an optimized interface. Blur’s key features include zero trading fees, mandatory low creator royalties (initially 0.5%), and an incentive-driven tokenomics model.

Blur has quickly risen to prominence, competing directly with traditional NFT platforms like OpenSea. At certain times, Blur’s trading volume surpassed OpenSea, capturing a significant share of the NFT trading market.

Despite Blur’s rapid growth, it faces challenges, including insufficient ability to consistently attract regular users, a decline in creator participation, and potential changes to royalty policies and protocol fees. As discussions on the “fee switch” proposal unfolded, Blur aimed to strike a new balance between token value capture and market competitiveness.

On November 12, 2024, Split Capital proposed a plan titled “BLUR Fee Conversion and veBLUR Tokenomics” on Blur’s governance forum.

Proposal Details

• Currently, the Blur NFT marketplace implements a 0% market fee and enforces a 0.5% creator royalty. The proposal suggests eliminating the enforced creator royalty and introducing a 0.5% protocol fee on each transaction.
• To adapt to market changes, the proposal recommends establishing a Fee Committee responsible for adjusting the protocol fee rate based on market conditions.
• The proposal introduces a dual-token model, consisting of BLUR and veBLUR. BLUR token holders can lock their tokens for up to four years to receive veBLUR. The longer the lock-up period, the greater the voting power. veBLUR will be used for governance, and holders will receive a proportional share of 100% of the protocol transaction fees, settled monthly.
• To incentivize users, the proposal suggests adding a 1% increase in total supply (30 million BLUR) in the current fourth season and distributing it based on users’ total scores at the end of the season.

Final Result

The community strongly supports this proposal because they view the fee switch and veBLUR tokenomics as valuable for users. They also particularly suggest aligning incentive mechanisms with governance and market dynamics. However, the proposal is still in the discussion phase and has not yet entered the voting process, so it has not been approved.

Ethena’s Fee Switch Design

Ethena (ENA) is a stablecoin protocol designed to generate USD-pegged stablecoins by converting value assets such as Bitcoin, Ethereum, and their derivative assets into long positions of BTC or ETH through futures contracts.

On November 7, 2024, Wintermute released a proposal. Ethena protocol has already generated considerable real income, which indicates that USDe has strong market adaptability. However, sENA has not directly benefited from this income, which results in a significant disconnect between sENA holders and the protocol’s growth. It is time to acknowledge this gap and seek a more direct connection between ENA holders and the protocol’s fundamentals.

Proposal Details

Implementation Plan

The specific implementation plan can be further determined in the future, but the following factors should be considered:

• What percentage of the protocol’s income will be redirected to sENA in some form?
• How will protocol income be distributed to sENA holders?
• The growth dynamics of the USDe supply.
• The competitiveness of sUSDe yields.

For example, direct distribution might not be feasible due to factors like the protocol’s maturity, among others. At the very least, we request enabling the possibility of redirecting protocol income to sENA.

Activation Conditions

Considering that Ethena might still be in the early stages of its lifecycle, it may not be appropriate to directly allocate a portion of the protocol’s income to sENA at this stage. We request that the Risk Committee provide a set of parameters and milestones to ensure that such allocations only occur once these conditions are met. These parameters, which the Risk Committee will determine, might include:

• The circulating supply of USDe.
• The total or average income of the protocol.
• The difference between sUSDe’s annualized yield (APY) and market interest rates.
• The adoption of USDe on major distribution platforms (e.g., centralized exchanges).

Since this would be a significant change in tokenomics, any final decision on implementation should be confirmed through a broader ENA/sENA vote.

Current Protocol Income

In the industry, there are examples of “dual-class” share structures, where shareholders may receive benefits that are not aligned with the interests of protocol or governance token holders. Transparency is crucial for the sustainable development of the industry and ecosystem. Given the current lack of public information, we want to clarify whether similar issues exist in the Ethena protocol.

We respectfully request the foundation to clarify whether 100% of Ethena’s income is solely used for the protocol’s benefit, or if there are other distributions. Additionally, we request confirmation that future income will continue to be managed within the Ethena protocol, ensuring these revenues benefit the protocol and are still governed by ENA/sENA.

We propose the following recommendations to the Risk Committee:

• Approve the proposal to allocate a portion of Ethena’s protocol income to sENA-related initiatives.
• Provide the conditions that Ethena must meet to submit the proposal to the ENA/sENA community for voting.

Final Result

On November 16, the Ethena Foundation announced that the proposal to enable the ENA fee conversion, put forth by Wintermute, was approved by the Risk Committee. The foundation will work with the Risk Committee to finalize the activation parameters for the fee switch by November 30.

In a public announcement in 2025, as part of the ecosystem built around sUSDe, the design of sENA aims to accumulate value like the BNB token model. A portion of the token supply will be reserved for applications within the ecosystem and airdropped to sENA holders.

This proposal was also put forward to improve value capture, aiming to encourage the Risk Committee to refine the tokenomics design and establish a more transparent distribution system for protocol value.

The Significance of the Fee Switch

Most DeFi tokens primarily offer voting governance functions, driven by considerations such as compliance, growth strategies, governance models, and economic design. Allocating protocol income may be viewed as a security action, which could introduce legal risks. As a result, many DeFi protocols limit governance token functionality to voting rights to avoid crossing legal boundaries. In the early stages of a protocol, many protocols prioritize distributing fees to liquidity providers (LPs) rather than governance token holders to attract sufficient liquidity and create market competitiveness. DeFi protocols often focus on community governance, empowering token holders with decision-making power rather than direct profit-sharing. This design aligns with the decentralized ethos. Some projects believe that the token value should be reflected in governance rights and ecosystem incentives, rather than just cash flow sharing, thereby supporting the protocol’s long-term sustainability.

As a result, many protocol tokens lack strong value-capture capabilities, which harms the interests of investors and the community and significantly impacts token market prices.

Activating the fee switch has significant implications for the protocol, governance tokens, liquidity providers, and the broader ecosystem. The impact on governance tokens is particularly notable. With fee-sharing enabled, governance tokens go beyond just voting rights and can directly benefit from the protocol’s cash flows. This could increase their market value and appeal. Furthermore, fee-sharing may incentivize more users to stake governance tokens, strengthening the protocol’s security and decentralization.

Activating the fee switch could impact liquidity providers by redirecting fees from LPs to stakers, resulting in lower earnings for LPs. This may prompt some to withdraw, reducing liquidity. To mitigate this, the protocol must provide additional incentives, such as higher token rewards, to sustain liquidity and prevent significant shortages.

From an ecosystem perspective, activating the fee switch helps optimize revenue. The protocol can gradually achieve profitability by allocating a portion of the revenue to governance token holders. This will attract more institutions and users, thus driving its ongoing development. However, the protocol must balance the interests of governance token holders and liquidity providers to ensure both are well-supported, thereby fostering long-term stability and growth.