Uniswap is a Decentralized Exchange (DEX) based on Ethereum used to trade ERC20 tokens. How does it work?
While most exchanges (Coinbase, Binance, etc.) charge a commission every time a trade occurs, The function of Uniswap works as a public good, a community tool to trade tokens without platform fees or intermediaries.
Unlike most exchanges, which put buyers and sellers in contact to determine prices and execute trades (order book), Uniswap uses a simple mathematical equation and pools of tokens and Ethereum to do the same job.
Uniswap is one of the leading products of the DeFi ecosystem and the Decentralized crypto Exchanges or DEXes. A DEX aims to solve many of their centralized counterpart problems, such as hacking risk and theft, mismanagement, and fees charged to users. However, Decentralized Exchanges have their problems, most importantly, the lack of liquidity, the shortage of money circulating through an Exchange that makes operations faster and more efficient.
Uniswap tries to solve the Decentralized Exchange liquidity problem, allowing the Exchange to trade tokens without depending on buyers and sellers to create that liquidity. Hayden Adams created Uniswap, inspired by a post from Ethereum founder Vitalik Buterin.
What's so special about Uniswap?
Uniswap's primary distinction from other decentralized exchanges is that it uses a pricing mechanism called the "Constant Product Market Maker Model."
This system allows users to add any token to Uniswap by financing it with an equivalent value of ETH and the traded ERC20 token. If you want to trade for an altcoin called Foo Token, you would launch a new Uniswap Smart Contract for Foo Tokens and create a liquidity pool with, for example, $10 Foo Tokens and $10 ETH. Uniswap makes the difference in that instead of connecting buyers and sellers to determine Apple Token's price, Uniswap uses the simple linear equation Y = (1/k) * X.
The amount of ETH and ERC20 tokens available in a liquidity pool are the X and Y in the equation, and k is a constant value. This equation uses the balance between ETH and ERC20 tokens and the available supply and demand to determine the specific token price. Every time someone buys a Foo token with ETH, the supply of Foo tokens decreases while the supply of ETH increases, and finally, this causes the price of the Foo Token to rise.
On Uniswap, token prices change if and only if a trade occurs inside the DEX. Uniswap balances the token's value and their trade based on what people want to buy and sell. Any ERC20 token can appear on Uniswap without the need for permission. Each token has its Smart Contract and a corresponding liquidity pool; if one doesn't exist, you can easily create one.
Once a token has its own Trade Smart Contract and liquidity pool, anyone can trade the token or contribute to the liquidity pool, earning a 0.3% commission as a liquidity provider. If you want to contribute to a liquidity pool, an equal value of ETH and ERC20 tokens is needed.
How are Uniswap tokens produced?
Every time a user contributes with new ETH / ERC20 tokens to a Uniswap liquidity pool, she receives an ERC20 token named Pool token.
When traders deposit funds in the liquidity pool, the platform creates new Pool tokens that can be traded, moved, and used on other available DApps. When someone claims the funds, the platform destroys the previously created Pool Tokens (burned, using crypto terminology). Pool tokens represent the user's share of the pool's total assets and their share of 0.3% of the pool's trading fee.
Although Uniswap launched in November 2018, it wasn't until recently that the protocol began to see significant traction. Much of this interest stems from the release of Uniswap V2 in May 2020, a significant update that allows direct swaps from ERC20 to ERC20, removing wrapped ether (wETH) from the equation when possible. Uniswap V2 can support previously incompatible ERC20 tokens such as OmiseGo (OMG) and stablecoins like Tether (USDT), adding several technical improvements that make their use more attractive.
As liquidity mining and yield farming platforms increased dramatically in 2020, Uniswap saw a corresponding increase in interest and popularity. Many DeFi platforms allow Uniswap's liquidity providers to see an additional return on their LP (Liquidity Provider) tokens.
In combination with the 0.3% trade commissions distributed to liquidity providers and the ability of the platform to act as a launchpad for popular DeFi project tokens has pushed Uniswap to the first places of the top DeFi platforms by Total Value Locked (TVL), a measure of the total value of crypto assets secured on the platform.
In February 2021, Uniswap became the first Decentralized Exchange to process more than $100 billion in trading volume, and it frequently exceeds $1billion in trading volume each day. This performance has made it not only the largest DEX by trading volume but one of the top five most popular exchanges.
Meanwhile, Uniswap's governance token (UNI) has risen to become the 8th largest cryptocurrency by market capitalization after reaching a peak value of more than $33. This success is due to the rising popularity of Yield Farming, where UNI or LP Tokens are usually required.
But not everything has been easy for Uniswap. Due to massive congestion on the Ethereum network, transaction fees have skyrocketed, making trading on Uniswap hard to trade, especially for small volume trades.
Ethereum gas fees have led to the proliferation and growth of a wide variety of alternative platforms, such as TRON's JustSwap, Qtum's QiSwap, and Kyber Network, which promise faster transitions, lower fees, or both. Uniswap has also recently seen its daily transaction volume briefly outpaced by PancakeSwap, a similar Automated Market Maker (AMM) built on top of Binance Smart Chain.
Uniswap is preparing Uniswap V3 to improve flexibility and reduce commissions, among other features.
Recently, one of the most anticipated events in the cryptocurrency ecosystem took place: the announcement of version 3 (v3) of Uniswap. The Decentralized Exchange (DEX) describes v3 as its "best-effort" to make Uniswap the "most flexible and capital-efficient automated market maker (AAM) ever designed."
Uniswap's growth has been extraordinary, as it has become the king of decentralized finance (DeFi) over the last year. With the rapid growth of users and value (TVL), Uniswap has had to reinvent itself just a year after launching version 2. And it has not disappointed.
Version 3 introduces new features that differentiate Uniswap from its competitors. Concentrated Liquidity stands as one of the most distinctive features that take Uniswap apart from its competitors. Concentrated Liquidity allows liquidity pools to choose in which price range they allocate their capital.
Uniswap v3 also offers LPs three different commission levels per pair: 0.05%, 0.30%, and 1.00%. "This range of options ensures that LPs can adjust their margins based on the expected volatility of the pair."
For LPs, this means that they can provide Liquidity in more volatile assets, as they can earn more commissions. Previously, the system charged a 0.03% commission for all trades on Uniswap pools. This model has worked well for some assets but has hurt others, the v3 white paper (PDF) notes.
Version 3 also updates the Uniswap Oracle. The V2 version introduced the concept of Oracle Time-Weighted Average Price (TWAP). They store the running totals of pair prices every second. They allow users to calculate an accurate TWAP over a trading period by checking the price at both ends of the trading session. TWAPs became a hit, and other big DeFi projects like Compound have incorporated them.
V3 enhances these oracles and gives them the ability to provide much more data over nine days. The new Oracles will be much cheaper, and they'll be easier to use. They will allow users to get data such as "Simple Moving Averages (SMA), Exponential Moving Averages (EMA), Outlier Filtering, and much more."
Uniswap is an Ethereum-based decentralized exchange (DEX) that allows anyone to trade ERC20 tokens. In September 2020, Uniswap launched its UNI governance token with an airdrop to anyone who had used the protocol before September 1st.
Uniswap has faced challenges from competitors like SushiSwap; Ethereum's rising gas fees have also sparked a move towards DEX built on other platforms like BSC. In principle, it looks like Uniswap will be moving from ETH to another network, maybe the Cardano blockchain. Hayden, the Uniswap creator, has been closely linked to Vitalik since the beginning, and the only thing he is contemplating is the switch to ETH 2.0.
The decentralized finance (DeFi) ecosystem aims to use decentralized, non-custodial financial products to replace centralized intermediaries in financial applications such as loans, insurance, and derivatives.