What is Uniswap?
Decentralised exchanges have become a hot topic this year.
Depending on your perspective, they are the best thing to happen to crypto, or they are the reason your Ethereum gas fees have been so high.
By allowing users a way to trade in a decentralised manner, their popularity has exploded over the last 18 months as traders, and hopeful newcomers, look to exploit some of these massive returns on investment.
DeFi has become the quickest way to land on the moon in 2021. At the top of the pile, at least in terms of brand recognition, is Uniswap. Which leads us to the question, what is Uniswap, and how does it work?
What is a DEX?
A decentralised exchange is similar to any other exchange, except it is hosted by its users rather than a government body, effectively making it nearly impossible to shut down.
Uniswap is an Ethereum-based decentralised exchange, or DEX, which allows anyone to swap ERC20 tokens.
If you would like a breakdown of the different types of exchanges, we conveniently already have an article about that topic. Make sure to check that out after finishing our article on Uniswap.
To summarise, a decentralised exchange is an exchange built on top of a blockchain network, such as Ethereum. This exchange then runs autonomously and without governance from a centralised body.
In the case of Uniswap, in September 2020, Uniswap launched its UNI governance token, effectively giving control from the developers into the hands of those who use the exchange most frequently.
Uniswap is an open-ledger, where the users maintain and update transactions on the network and receive UNI tokens as a reward. In addition, these tokens act as governance tokens that can either be traded or used as a vote in proposed protocol updates.
A benefit of decentralised exchanges is their ability to be immune from censorship.
Without a central body and no clear figurehead behind the organisation, it becomes near impossible for any government to shut down. Therefore, as long as the internet is running, decentralised exchanges will be working too.
This benefit is demonstrated clearly in China, where the government has prohibited all crypto activity.
While centralised exchanges face prosecution for continuing to trade with Chinese users; who can you try to prosecute when the company is run by its users and hosted in multiple locations outside the jurisdiction of any individual nation?
So, how does this all work?
Demand for decentralised, non-custodial financial products
The current DeFi, or decentralised finance, trend has been created by the demand for decentralised, non-custodial financial products to replace centralised intermediaries in financial applications such as loans, insurance, and derivatives.
Uniswap finds itself as a backbone to this new digital economy. While competitors exist, Uniswap and its clone-based competitor, PancakeSwap, win regarding brand recognition, regardless of whether they are top by market share or not.
By providing a platform that facilitates the trading between individuals, Uniswap, as one of DeFi’s premiering decentralised exchanges, aims to solve the problems associated with regular centralised exchanges.
To participate on a DEX, you must first install a crypto wallet, thus already making you infinitely more secure than those who’ve left their funds on a centralised exchange’s web wallet, also known as their ‘hot wallet.’
These hot wallets have been a constant source of misery for crypto holders. While MtGox is perhaps the most famous in 2014, even exchanges like Binance aren’t immune, having suffered a significant security breach in 2019.
We strongly recommend a crypto hard wallet for every crypto investor. Even using a desktop or web wallet will significantly reduce your chances of being hacked.
That is because, once you trade, it’s no longer left on the exchange but instead in your wallet, giving decentralised exchanges at least one edge over their centralised counterparts.
Eradication of mismanagement
Furthermore, another aim Uniswap plans to eradicate is mismanagement.
To further this objective, Uniswap gave control of the exchange to its users via airdropping governance tokens to those who had used the exchange before September 2020.
The number of tokens users received was proportional to how much they had used Uniswap before that date.
Effectively removing mismanagement from the equation and having been launched sensibly resulted in no retail wallets exceeding 2.5%, keeping whale manipulation to a minimum.
Therefore, the fate of Uniswap relies solely on its users’ wise guidance, ruling out the mismanagement that can often be the downfall behind many fledgling start-ups as they begin to scale.
Lastly, although not free, DEXs typically cost less to complete each transaction compared to centralised exchanges.
However, the main disadvantage to the decentralised economy is liquidity and the threat of poorly written smart contracts.
There isn’t enough liquidity on certain decentralised exchanges to carry out large trade orders, which can be disastrous if looking to exit a significant position quickly.
Yet, Uniswap aims to tackle this problem by allowing the exchange to swap tokens without relying on buyers and sellers directly, creating constant liquidity.
Unlike most exchanges, which match buyers and sellers to determine the price and execute trades, Uniswap uses a mechanism called the “Constant Product Market Maker Model.”
Users can add any ERC20 token to Uniswap by funding it with an equivalent value of ETH and your chosen ERC20 token. To determine the price of an asset, Uniswap uses a constant equation: x * y = k.
In the equation, x and y represent the quantity of ETH and ERC20 tokens available in a liquidity pool, while k is constant. Using this equation, Uniswap uses the balance between the ETH and ERC20 tokens to determine the price of a particular asset.
Whenever someone buys an ERC20 token with ETH, the supply of said token will decrease while the supply of ETH increases. Thus, increasing the price of the ERC20 token in the process.
Due to this process, the price of tokens on Uniswap only changes if trading occurs. In short, Uniswap is balancing out the value of assets in the liquidity pool and automatically swapping them based on how much people want to trade.
The downside here is, once live, these smart contracts cannot be altered. Thus, a specialised team of experts in smart contract coding is required to analyse if the code from which this smart contract is based can be exploited later or not.
While this code is open-source, until the level of crypto literacy generally increases, that is akin to giving the dog your car keys.
Of course, giving the dog the car keys doesn’t affect much, as, without much concept of what a car is or does, those keys cannot be utilised fully.
So, when you usually hear about DeFi hacks, it’s most likely due to poorly written and easily compromised smart contracts.
Uniswap as an Accessible Market
In addition, no prior permission is required to list any ERC20 token on Uniswap either, as each token has its own smart contract and liquidity pool.
As a result, anyone with a smartphone and internet connection can get involved, ultimately making Uniswap one of the most accessible marketplaces on Earth.
If you find there isn’t a current liquidity pool, one can easily be created by funding the liquidity pool yourself, which will, in turn, give you liquidity pool tokens, or LP, for doing so.
When providing liquidity for an ETH/ERC20 liquidity pool on Uniswap, the contributor receives LP, an ERC20 token that can also be traded freely on the exchange.
Each LP token represents a user’s share of the pool’s total assets and a portion of the pool’s 0.3% trading fee. So naturally, this incentivises people to fund these liquidity pools.
In addition, to ensure no double-spending occurs, these liquidity pool tokens are automatically burned when reclaiming LP funds.
Anyone in the world can trade these tokens or contribute to the liquidity pool and earn a liquidity provider fee of 0.3%, resulting in opportunities never before seen for the world’s unbanked, which still accounts for almost a third of the total global population.
Though, to provide liquidity for a pool, you need an equal value of ETH and ERC20 tokens to begin, which is always something to remember.
To summarise, decentralised exchanges are a way to trade without intermediaries.
Uniswap as a decentralised exchange
Uniswap acts as one of the top decentralised exchanges. Yet, its unique selling point is the automatic market maker they have introduced, which removes the requirement for lone individuals to fund a pool, resulting in markets staying liquid 24/7.
Uniswap allows the trading of digital assets automatically, in a permissionless way, by using automated liquidity pools rather than a traditional market of connecting individual buyers and sellers.
These Automatic Market Makers, or AMMs, supply liquidity pools with crypto tokens, whose prices are determined by a constant mathematical formula.
Although having talked about most of the pros above, such as decentralisation, automatic market makers, no centralised governance, the one con we didn’t talk about is competition.
As DeFi has been such a driver for the markets in this most recent bull run, it won’t come as a surprise that Uniswap is currently facing a lot of competition. Including the likes of PancakeSwap, which is essentially UniSwap but on the Binance network rather than Ethereum’s.
While competition generally makes products more robust, it does also lead to a problem of over-saturation. Although crypto, including DeFi, probably isn’t a zero-sum game with many potential winners predicted as we move deeper into the future digital economy.
Confusion regarding decentralisation
Lastly, there seems to be some confusion regarding decentralisation. Recent reports suggest that the developers still hold between 20% and 60% of all UNI tokens.
If this is true, it would mean Uni is not as decentralised as it claims. However, it seems likely this 60% figure includes the 40% of UNI tokens currently acting as liquidity for the exchange, which, while substantial, is not so surprising.
Regardless, Uniswap is most likely here to stay. Having been one of the pioneers in the space and having held the highest average trading volume through DeFi’s short existence, we feel the first-mover advantage will be enough to keep Uniswap going long into the future.
The only elephant in the room is the incoming crypto regulations. With decentralised exchanges being near the top of the hit list, we could see Uniswap targeted.
Luckily, the development team behind Uniswap, despite being a decentralised exchange, have preemptively gone out of their way to try and avoid potential conflict by becoming as regulated as they can be while maintaining their decentralised status.
Therefore, likely securing the network’s future even in the wake of the upcoming crypto regulations.
We hope you have found this article informative, and you are leaving with a better understanding of what Uniswap is and how it works. If you would like to learn more, make sure to check out some of our previous articles next.
For further information regarding Uniswap go to their official website.
Elbaite is the cryptocurrency exchange designed for Australian traders seeking safety, security and simplicity. Make an account today to start your Uniswap investment journey!
Disclaimer: The information on this website is purely for information. Elbaite is not a financial adviser, and nothing stated here is to be taken as financial advice. You should seek independent legal, financial, taxation or other advice relevant to your financial situation before making any investment decisions.
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