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What is Uniswap and how does this leading DEX work?

Uniswap is the leading decentralized exchange that is being used more every single day. It is one of the most innovative cryptocurrency projects that have risen from DeFi sector and has a lot to offer, which is the reason why we fundamentally analyse this platform.

The world of decentralized finance (DeFi) experienced a huge increase in popularity and usability in 2020. Dozens of new and interesting projects have been added to DeFi, with a large number of them coming to the forefront mainly thanks to community support. One of the most important categories in the world of DeFi is the decentralized exchanges (DEX), which aim to create better trading options for cryptocurrency investors. The best known, largest and also the most used DEX exchange is Uniswap, which we will discuss in this article.

History

The founder of Uniswap is Hayden Adams, who published the whitepaper of Uniswap on his Twitter account on November 2, 2018. This exchange is unique mainly due to the fact that it was able to get among the top projects without ICO or any other form of fundraising. Financial support did not come until 2019, when Paradigm Capital invested $ 1 million in the project, and then in August 2020, private investors led by Andreessen Horowitz joined with approximately $ 11 million.

Meanwhile, on May 18, 2020, a new version of Uniswap was released, an upgrade to Uniswap v2, which brought more robust security and solutions to problems with oracle and flash loan hacks, which cause significant losses in the DeFi world. The functionality and simplicity of the user interface of the entire platform has also been improved.

There are two other significant events in the history of the Uniswap exchange. One of them happened at the beginning of September 2020, when after a very successful year in terms of the increase in Total Value Locked (TVL), this Uniswap statistic suddenly began to decline. The reason was simple. The fork of the Uniswap exchange, called Sushiswap, was launched, and used so-called "vampire tactics" to profit from the popularity of the Uniswap exchange.

In short, the DeFi exchange Sushiswap, which was created only at the end of August (August 26, 2020), copied almost everything from the Uniswap exchange and thus represented an automated market maker exchange, but added to this system a governance token, SUSHI, which suddenly represented a financial reward for those, who moved their liquidity from the Uniswap exchange to Sushiswap. Sushiswap simply changed its user interface, adding financial incentives for users to move their liquidity from Uniswap to Sushiswap, and brought the TVL of that exchange from zero to $ 1.42 billion in less than a week.

By contrast, Uniswap lost most of its liquidity in this move, with TVL falling from $ 1.82 billion to about $ 400 million. If the Uniswap exchange did not want to lose all of its liquidity, it had to take a major step. Therefore, Uniswap launched a governance token, UNI, which levelled the scales with projects such as Sushiswap, added a financial incentive for users to return liquidity to Uniswap, which again increased TVL and pool liquidity.

How does Uniswap work

Uniswap is a decentralized, automated market making exchange built on Ethereum that provides liquidity through so-called liquidity pools (LPs), in which users can exchange their ERC-20 tokens between two different assets. These can be converted to a given exchange via a Web 3 wallet such as MetaMask, Coinbase Wallet, Formatic, Portis or Wallet Connect. At the same time, Uniswap works completely differently from traditional centralized exchanges. The main reason is the removal of order books, which was replaced by the Constant product market maker model. It allows the use of liquidity in the selected pool (which represent a trading pair) and adjusts the price either up or down based on the relative size of the pool. In this way, it is also guaranteed that the pool will never lose its liquidity. Simply put, when trading on Uniswap, you just choose the cryptocurrency you want to exchange (sell - for example, ETH) for the cryptocurrency you want to get (buy - for example, USDT) and Uniswap will do it for you at market value. Of course, it will also show in advance the expected number of tokens you will receive. At this point, it must be said that this is really only an estimated number, because there can be a slippage (difference in the amount between entering the trade and executing the trade), price impact and, of course, deducting the fee, all of which can expect the amount you entered. token change. Therefore, before each trade / exchange (swap) on Uniswap, it is necessary to look at the following orders (according to the example).

Minimum received (2,203 USDT): a guarantee of the smallest number of tokens you will receive if the price of the token you selected moves against you at the time of your trade. If you are not willing to accept the lowest number of tokens you will receive for a given trade, you should not proceed, because even though the possibility of receiving the minimum amount of your chosen token is small, it may occur due to slippage.

Liquidity provider fee (0.000021 ETH): approximately 0.25% to 0.3% of the transaction

Price Impact (<0.01%): in the case of a small pool liquidity, it is possible that your trade will "move the price" of the token you have to receive, which means that its price will move up, so you may get fewer tokens as originally estimated. Price impact depends on the amount you enter, but also on the amount of liquidity of the pool. It is also true that the greater the price impact of your trade, the greater the chance of obtaining a lower number of tokens. For example, a price impact of <0.01% is very small, so a price impact should not occur.

Slippage tolerance (0.5%): protects you from receiving too few tokens of your choice. In the case of a small slippage tolerance, it can cause the transaction to be cancelled.

Transaction deadline (20 minutes): is responsible for ensuring that the transaction is completed within the time limit. If this does not happen, it will be rejected and you will get back the cryptocurrency you entered (Ethereum).

Providing liquidity through LP

Exchanging ERC-20 tokens is not the only functionality that Uniswap offers. The second way to use Uniswap is to provide liquidity to one of the pools, for which the liquidity provider can obtain fees from the given pools. When providing liquidity to a pool, it is important that the dollar value of the two tokens provided - for example, ETH and PAX - is the same. Once a person provides liquidity, he receives a so-called "Liquidity tokens," which he can exchange back at any time for his original tokens. "Liquidity tokens" only serve as a confirmation of the provision of liquidity, while also allowing the liquidity provider to see any increase or decrease in the value of the assets, but no loss should be made in dollar value (therefore the same value should be entered in both assets at the beginning).

Liquidity pools also provided an interesting opportunity to make money through various liquidity strategies. For example, if you believe that a certain trading pair has the potential to be more traded in the future, you can provide liquidity in it. If your estimate comes true, a higher number of transactions means a higher number of transaction fees, which means higher fees that are redistributed among liquidity providers.

However, you should also be aware that the higher the liquidity, the smaller the share of the given LP you own and the smaller the share of transaction fees you will receive. The logic behind the model that Uniswap uses is simple. The higher the liquidity -> the smaller the slippage and price of pair of tokens is fairer -> the higher the interest in this currency pair should be -> means larger number of trades and thus an increase in the total trading fees of the pair -> causes higher earnings for liquidity providers, who will be motivated to provide it in other LPs as well. In this way, Uniswap seeks to encourage the provision of liquidity.

Advantages of the Uniswap exchange

First mover advantage: Uniswap is the largest and most well-known name in the DEX world, with daily transaction volumes comparable to leading CEX exchanges. Compared to other DEX exchanges, it is one step ahead, with Curve Finance and Sushiswap keeping the pace with this exchange as much as possible.

Noncustodial: Unlike centralized exchanges, Uniswap and DeFi themselves are based on the fact that ownership and responsibility for tokens lies solely with their holders. This prevents the trader's funds from being frozen or lost through a hack. In the case of Uniswap, you are still solely responsible for your keys.

No KYC: know-your-customer often encounters resistance in the cryptocurrency world, which is why Uniswap is also for those who do not want to verify themselves on exchanges and try to maintain privacy. There is no need for verification by passport, ID or other identity document. It also eliminates the possibility of stealing or disclosing details about you, which for instance happened in mid-December 2020, when the Ledger hack led to the disclosure of 270,000 home addresses and 1 million email addresses to Ledger's clients. This is not the case with Uniswap.

Easy access to new cryptocurrencies: because Uniswap is decentralized, there is no approval or selection process to decide which cryptocurrency will be listed. New cryptocurrencies are therefore included here relatively quickly, which makes Uniswap interesting due to its offer, especially of smaller lowcap tokens.

Low fees: Uniswap also has lower fees, as is the case with centralized exchanges. Here, of course, it mainly depends on which stock exchanges and in which volumes you trade, but with fees of approximately 0.3% of the trade, Uniswap is one of the cheaper ones.

Very simple UI: unlike its predecessor, such as EtherDelta, Uniswap is one of the simplest and most transparent exchanges in the market in terms of visual interface. No order books, complicated shop settings and the like. Just a simple and clear entry of 2 tokens that you want to exchange or provide liquidity to the LP you desire.

Disadvantages of the Uniswap exchange

Lots of scams: easy access to new cryptocurrencies is one of the advantages, but it can also be seen from a negative point of view. Since theoretically any ERC-20 token can get to Uniswap a lot of scams and fake cryptocurrencies can get there. That is why when buying cryptocurrencies, which are only on Uniswap, it is necessary to look for more about the cryptocurrencies and make your investment obligation in a thorough review of the project.

Transaction failure: This is also one of the problems that can occur on Uniswap. These can occur, for example, with a low gas fee, which was not profitable for the miner and thus the transaction was not processed. There may also be a problem with the lack of liquidity in the pool at the time, which would again lead to non-processing of the transaction. However, this is especially a problem with very small tokens with low liquidity and is relatively unlikely to happen with a larger pair.

Regulators: a disadvantage for the future may also be regulators who may try to outlaw the use of Uniswap, as the user or trader does not need to go through KYC. The US authorities have problems with this, but no one can rule out the possibility that greater pressure on the KYC will not be exerted by regulators from Europe or Asia. Even if that happened, Uniswap and the use of any token governance would have to be completely outlawed, as banning a decentralized exchange would be more than difficult.

The Uniswap exchange, with its UNI token, is one of the flagships of decentralized finance. This DEX has certainly helped boost DeFi, helped with its security and functionality, and in the process has built up great community support. Although it has a few disadvantages, if the DeFi world grows, it is very likely that the use and popularity of the Uniswap exchange will also grow.

Marek is a cryptocurrency enthusiast with several years worth of experience in the industry. He has been working with numerous cryptocurrency and FinTech projects, where his main r...

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