What is Uniswap?
Uniswap is a liquidity protocol running on the Ethereum blockchain which allows for decentralized token swaps. Its logo, a unicorn, is a reminder of the magic that this truly innovative protocol brought to the DeFi space. Thanks to Uniswap, traders can swap their Ethereum based tokens without having to trust a third party. As tokens are directly sent to Uniswap’s smart contract instead of a centralized exchange, only code has to be trusted. There are no centralized intermediaries, which guarantees high censorship-resistance and decentralization.
Meanwhile, Uniswap also allows anyone to lend their Ethereum based tokens to liquidity pools, which are special reserves that make token swaps possible. In exchange for providing liquidity to these pools, lenders earn fees for every swap happening in their pool.
As a result of this innovation, Uniswap has become one of the most successful protocols on Ethereum and the largest decentralized exchange DEX within the DeFi movement.
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How Uniswap works
Since its early days, the crypto world has often been criticized for enabling permissionless, decentralized networks with their unique coins and tokens that are, however, only tradable via centralized exchanges. Subsequently, attempts were made to create decentralized order books directly on the blockchain. However, due to the inherent scaling limitations of blockchain technology, these ventures never really took off and no meaningful competitors to centralized crypto exchanges emerged.
With the advent of Uniswap, this changed drastically. For the first time, Uniswap’s innovation provided an efficient and user-friendly way to swap tokens in a decentralized manner. It’s innovative approach leaves out order books completely and instead works with ‘automated market maker’ (AMM) protocols. AMM are smart contracts holding liquidity reserves, often referred to as liquidity pools, that traders can trade against. A pool generally holds one currency pair, e.g. Ether and Uniswap (ETH/UNI). These pools are filled by liquidity providers and anyone can participate in providing liquidity. To participate, the equivalent value of two tokens, i.c. ETH and UNI, have to be deposited in a pool.
A trader wanting to swap ETH for UNI now sends ETH to the pool and receives the equivalent value back in UNI tokens or vice versa. Unlike in traditional finance, there is no official exchange rate for a token pair, but the protocol automatically adjusts the exchange rate of a pool depending on the token ratio in the pool. The more the ratio deviates from the original 50/50 ratio, the more expensive the underrepresented coin gets in comparison to the overrepresented one. This mechanism is simply based on supply and demand. As each pool works insulated from others and from the market as a whole, price deviations are smoothed out by arbitrage traders, which utilize exchange rate disparity among pools, platforms as well as between the pool and the market.
For each swap, traders pay a small fee to the liquidity providers. The more volume a pool generates, the more fees liquidity providers earn in return. But, as anyone can participate in providing liquidity, high returns won’t go unnoticed by the market and attract more liquidity providers. Usually, returns are fairly high though, but no without reason. Providing liquidity can come with significant risk. If the prices of the two tokens in a pool don’t develop at the same pace or in opposite directions, the better performing token will slowly get drained from the pool because the exchange rate within the pool usually lags behind the real market rate on centralized exchanges. Arbitrage traders will therefore swap tokens in the pool until the exchange rate in the pool reflects the real market rate again. As a result, the pool and its liquidity providers are left with more of the underperforming and less of the overperforming tokens. If the token’s exchange rate doesn’t bounce back to the original ratio, the liquidity providers are left worse off and speaking in financial terms it would have been better for them to simply hold the two tokens in their wallets. In the literature, this effect is known as impermanent loss.
Therefore, as a liquidity provider, carefully select your pool and the coin pair, have a rough idea of the tokens possible future price developments and be aware of the risk of impermanent losses. Alternatively, liquidity can be provided to stablecoin pools, e.g. USDC/USDT, which have fixed exchange rates and therefore no risk of impermanent losses but also generate lower returns.
In general, AMM protocols are a huge success so far. Uniswap consistently ranks among the top fee generators on the Ethereum blockchain and with an all time volume of over 300$ billion USD and over 57 million trades since its launch, it has become one of the cornerstones of today’s DeFi world.
what are uniswap tokens?
UNI is the native token of the Uniswap protocol and works as a governance token. It entitles its holders to vote on changes and new developments to the protocol including changes to the fee structure and the distribution of minted tokens. The UNI token was originally created in September 2020 in order to keep users from switching to the rival DEX SushiSwap. Sushiswap, which is a fork (code copy) of Uniswap and offers the same functionalities, had one month prior launched its own governance token SUSHI. Their token launch in parts was an attempt, some even say attack, to encourage users to reallocate their funds to the new platform by rewarding them with SUSHI tokens.
In response, Uniswap minted 1 billion UNI tokens themselves and decided to distribute 150 millions of them to each wallet address which had ever used their platform up to this point. Each address received 400 tokens, which are currently valued at 20$/coin. In general, 600 million tokens in total will be distributed to the Uniswap community members, while 40% are reserved for team members, developers and investors.
Part of the community token distribution also happens through incentivizing liquidity provision to certain pools on Uniswap. In addition to the fees earned, liquidity providers in these pools get UNI tokens distributed to them as an incentive to provide liquidity to the Uniswap platform and not to some of its competitors.
In the long run, the value of the Uniswap token is very difficult to determine. So far, it is simply a governance token, with no rights to future cash flows, no staking possiblilty and no ownership rights. For long-term investors this raises the question: what is a one in a billion governance right on the Uniswap platform worth? And will the majority of token holders ever vote to distribute a share of the platform’s fees to the token holders? So far, the platform and the token seems to act like sort of a public good, which makes a valuation extremely difficult.
How to use uniswap
Uniswap works like a true decentralized exchange, meaning its developers have no way to remove a smart contract once it has been deployed on the blockchain. To make innovative changes to Uniswap, a new version of the protocol has to be launched. The old version stays on the public blockchain and users can use both versions according to their liking. Recently, Uniswap has launched their 3rd version of the protocol, Uniswap V3, which introduced a lot of new features such as lower fees through second layer solutions, more flexibility to liquidity providers and in general a higher capital efficiency.
Users visiting Uniswap.org will automatically be presented with the newest version V3 but still have the option to switch to the older Version V2. To swap tokens over Uniswap, open the Uniswap App. Once open,
- Hit the ‘connect to wallet’ button on the top right corner.
- Connect your Ethereum wallet using one of the presented options. Most wallets let you scan a QR code or offer a browser plug-in to connect to the protocol.
- Once connected, the swap mask opens up. Choose the tokens and the amount you’d like to swap. The mask will display your token balance and the offered exchange rate.
- Hit ‘swap’. The protocol then presents to you the details of the swap, such as liquidity provider fees and slippage. If all is to your liking, click ‘confirm swap’.
- Open your wallet. The protocol has now sent a message to your wallet, displaying the payable Ethereum gas fees. Make sure you have enough Ether in your wallet to pay for the transaction, then confirm the transaction in your wallet.
- Within minutes, the swapped tokens will show in your wallet.
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