What is Uniswap

Uniswap is a decentralized cryptocurrency trading protocol created on November 2, 2018, by former Siemens mechanical engineer Hayden Adams.

A community of UNI token holders manages the Uniswap protocol. This community votes on proposals for the protocol and how it should operate.

Uniswap is based on Ethereum, aiming to stimulate a global network of users to maintain an exchange where traders can buy and sell cryptocurrencies. Uniswap eliminates trusted intermediaries and fees by enabling safe, affordable, and efficient exchange activity.

The Uniswap blockchain is open source, meaning anyone can view and contribute to the development of the network.

How to work with the Uniswap platform?

First of all, you need to have a wallet supporting ERC-20 tokens – like MetaMask.

Once you have added the wallet to the browser, you need to add ETH to it to trade on Uniswap and pay for the gas fees. Gas payments vary in price depending on how many people use the network.

Most wallet services compatible with ERC-20 give you three choices when making a payment through the Ethereum blockchain: slow, medium, or fast. This determines how miners on the Ethereum network quickly process your transaction.

Uniswap is one of the leading decentralized cryptocurrency exchanges that outperforms traditional financial structures like banks. As its users increase, Uniswap releases successive versions with updated protocols.

Uniswap v1 was released to the main Ethereum network in November 2018. With Uniswap, trading assets requires proper matching of buy/sell orders between traders. An order remains unexecuted if the sell order does not match existing buy orders, which affects liquidity.

Uniswap v1

Uniswap is based on an automated market-making (AMM) protocol. No need for order books here. Trades are against smart contracts or liquidity pools; a mathematical formula determines the asset price. Liquidity providers add liquidity to the pools, which helps make a market.

Uniswap’s pools contain two tokens representing a trading pair for the given assets.

The company uses the formula (x * y = k) to determine the price of the pair, in which X and Y represent the pool balance for each token, and K is the total, constant price of said pool. 

In a newly created pool, the first liquidity provider determines the initial asset price by providing an equal value for the two tokens. 

Buyers can exchange tokens within the pool based on the formula. Smart contracts running the protocol use the formula to take the number of tokens from the buyer and send back an equivalent amount of tokens, keeping the overall pool price constant.

Each transaction has a fee associated with it, which means the total liquidity in the pool increases, making the system profitable for liquidity providers. 

As a result of this price change, if another buyer makes a trade in the same direction, they will receive a slightly worse rate for their trade, helping to keep the overall system in balance.

In reality, Uniswap enables users to trade cryptocurrencies without any involvement of a centralized third party. Instead of maintaining a central order book where buyers and sellers can submit orders, Uniswap uses liquidity pools. Deposits into these pools are essential to Uniswap’s operations, as users can then buy and sell cryptocurrencies from the liquidity pool, exchanging one token for another. Anyone can register a token on Uniswap as long as there is a liquidity pool for traders. However, Uniswap is built on Ethereum, which means it does not offer tokens traded on other blockchains.

To create a new pool, provide liquidity, exchange tokens, or vote on governance proposals, you need to go to the Uniswap interface and connect a Web3 wallet.

Uniswap v1 also facilitates the concept of LP tokens. When liquidity providers (LPs) add liquidity to a pool, they receive LP tokens representing the added liquidity. These LP tokens can then be stacked or burned to redeem the rewards. A trading fee of 0.3% is charged to reward liquidity providers.

UNISWAP v2

The proof of concept (PoC) of Uniswap v1 was a great success, and this has given the network the impetus to release an updated version in May 2020. The main drawback of Uniswap v1 was the “ETH bridge” problem, i.e., the lack of pools of exchangeable ERC20 tokens. This led to escalating costs and high slip jobs when a user wanted to exchange one ERC20 token for another.

Uniswap v2 is much better than v1 in terms of UI, eliminating the blockchain bridging issue. Another significant difference is the use of “wrapped” ethers (wETH) in the underlying contracts instead of traditional ETH. However, traders can use ETH through auxiliary contracts.

Uniswap v2’s flash swap concept allows users to withdraw any amount of ERC20 without paying upfront. They can either pay for the tokens withdrawn, pay for a portion, and return the rest, or return all the tokens withdrawn. These things can be done at the end of the transaction execution.

Uniswap v2 also introduced a fee for the protocol. The protocol fee of 0.05% of the total trading fee of 0.3% will be retained for the development of the Uniswap platform that shapes the network roadmap. Community management plays a vital role in enabling/disabling this fee.

Arbitrage trading

Arbitrage trading is an integral part of the Uniswap ecosystem.

What arbitrage traders do on Uniswap is find tokens that are trading above or below their average market price – as a result of large trades creating an imbalance in the pool and driving the price down or up – and buy or sell them accordingly.

They do this until the token’s price rebalances with the price on other exchanges, and no more profit will be made. This harmonious relationship between the automated market-making system and the arbitrage traders is what keeps the Uniswap token prices in line with the rest of the market.

Participation in Uniswap activities

Creating new markets: users can use smart contracts to create new markets to exchange new pairs of digital assets.

• Exchange assets through existing markets: Users can use the platform to exchange digital assets through decentralized markets.
• Providing liquidity and receiving rewards: Users can provide liquidity by staking, agreeing not to trade, or selling their digital assets. Those who stake their digital currencies on the Uniswap platform are rewarded with UNI tokens.
• Access to Uniswap management: UNI token holders are authorized to manage the Uniswap platform with voting rights allocated in proportion to users’ UNI balances.

Some of the potential benefits of decentralized exchanges like Uniswap include the following:

• Security: funds are never transferred to a third party or generally subject to counterparty risk (i.e., entrusting assets to a custodian) as both parties trade directly from their own portfolios.
• Global and without the need for authorization: there is no concept of limits or restrictions on who can trade. Anyone with a smartphone and an internet connection can participate.
• Easy to use and pseudonymous: No account registration or personal details are required.