Uniswap is one of the first decentralised exchanges (DEXs) in the decentralised finance (DeFi) ecosystem to effectively address some of the key concerns attributed to centralised finance – centralised exchanges (CEX), for example.
Notably, Uniswap was tackling critical challenges related to centralised middlemen in financial applications like loans, insurance, and derivatives. Furthermore, the DEX platform was providing a scalable alternative to various CEXs that were facing other major difficulties such as hacking, arbitration, and general mismanagement. Just before we dive in deeper, let’s take a moment to learn about a brief history of Uniswap.
Brief history of Uniswap
Founded by Hayden Adams, in 2018, Uniswap initially launched as a non-tokenised DEX exchange. However, about two years later, following the rise of tokenised DEX platforms like Sushiswap etc, Uniswap re-launched as an upgraded version 2 and subsequently, version 3, enabling advanced features such as direct swap between any token built on Ethereum, capital efficiency, and access to NFT Liquidity pools.
Also, in September 2020, Uniswap launched its native token UNI which saw the protocol airdrop 400 UNI tokens each to anyone who had completed transactions on the network prior to the time of launch.
While Uniswap wasn’t the first of its kind, it was the first to effectively address a prominent problem found among the DEX frontrunners; one that was inherent in the lack of liquidity pool. By lacking liquidity pools, the first set of DEXs suffered slow and less efficient trading activities.
On the other hand, Uniswap was able to resolve the issue by allowing the exchange to swap tokens without relying on buyers and sellers creating that liquidity.
Because it was one of the first and truly decentralised DEXs in the DeFi ecosystem, Uniswap was positioned as a standard for other DEXs that debuted thereafter in the DeFi market. And even though, it was touted to have a complicated user experience, Uniswap has since evolved to offer simpler and in-demand solutions.
What is Uniswap?
Uniswap is a decentralised protocol built on Ethereum that facilitates swapping or exchange of ERC-20 tokens. Just as mentioned earlier, the DEX platform eliminates the role of a centralised intermediary while executing financial activities such as loans, yield farming, and insurance.
In other words, traders (buyers and sellers or exchangers) can exchange Ethereum tokens without having to trust anyone with their funds, neither having to wait for a confirmation from any third party.
By leveraging multiple crypto assets including UNI, the network’s native asset, Uniswap provides a service that is identical to other traditional exchanges. However, the major difference is that it operates a rather decentralised administration that does not rely on a central order book as in the case of traditional exchanges.
Notably, Uniswap allows users to trade against a liquidity pool that is made ready by liquidity providers (LPs). LPs, for example, contribute to Uniswap pools by first securing two assets in a smart contract through a process known as staking.
The DAI/ETH liquidity pool at Uniswap, for example, is made up of deposits of equal value in DAI and ETH, and it is the same for every other asset that is traded within the network.
Furthermore, in order to maintain the liquidity pool, LPs are rewarded with a portion of the trading fees paid by traders – those who are buying, selling or swapping from the liquidity pool.
How does Uniswap work?
Uniswap, also known as an automated liquidity mechanism, does away with the traditional exchange’s order book model. Instead, the DEX platform chose a more advanced underlying technology known as Constant Product Market Maker (CPMM), which is a more advanced version of the Automated Market Maker (AMM) initially used by first-generation DEXes.
Simply put, the AMM model allows traders to trade against a readily available liquidity pool, rather than being paired against another trader. Hence, there are two main categories of users; the LPs, and the traders.
The LPs as explained earlier provide liquidity for traders, and in return, get rewarded from the fees remitted by traders. The liquidity provided is usually a combination of ETH and any other ERC-20 token, or in other cases, a combination of two ERC-20 tokens (both ETH/DAI or DAI/USDT can be staked in the Liquidity pool respectively).
Traders, on the other hand, can trade against the liquidity pool which consists mostly of stable coins, by simply paying a fee which is then accumulated and paid as incentives on the network’s reward system.
Generally, Uniswap employs the formula (x * y = k) to determine the pricing for the paired liquidities. The derivatives ‘x’ and ‘y’ respectively represent the pool balance of each token and the total, constant price of the specified pool in this calculation.
To establish the price of a token, this formula takes into account the balance between ETH and ERC20 tokens, as well as supply and demand.
Ultimately, the price of tokens on Uniswap are subject to trade activities. Uniswap is essentially adjusting the value of tokens and their swapping based on how much people desire to purchase and sell them.
Uniswap native token – UNI
Uniswap, like other decentralised protocols, has its own native asset- UNI, which aside from being a utility token, grants token holders the right to participate in the network governance. This further implies that UNI holders can vote for or against changes or modifications on the network, as well as have a say in other decision-making processes.
At inception, one billion UNI tokens were created and over, the course of four years, 60% of those were distributed to existing Uniswap community members, while 40% were made available to team members, investors, and advisers.
Lastly, UNI is also awarded as incentives (through a process known as liquidity mining) to those who provide liquidity to specific Uniswap pools.
Disclaimer: The views and opinions expressed by the author should not be considered as financial advice. We do not give advice on financial products.