Uniswap – Decentralised Exchange Without Borders
The following blog will introduce you to another cryptoasset from our dynamic portfolio – the decentralised Uniswap exchange. Uniswap, built on top of the Ethereum network, is currently the most popular decentralised exchange.
The Birth of Uniswap
The concept of the decentralised stock exchange Uniswap was born from the idea presented in 2016 by Vitalik Buterin, the founder of the smart contract platform Ethereum. Buterin proposed creating a decentralised exchange at the top of another blockchain network that would use the automated market maker (AMM) method with certain unique features, replacing traditional order books.
A year later, the founder of Uniswap, Hayden Adams, took the idea into his own hands and began working to transform it into a functioning decentralised protocol. After receiving various grants and a $100,000 donation from the Ethereum Foundation, Adams officially launched the Uniswap decentralised exchange in November 2018.
Adams was initially concerned not only about the basic security of the project but also about relationships with potential investors – he feared it might not be possible to persuade people to trade only with smart contracts without third-party interaction.
However, Uniswap has quickly become popular with traders worldwide due to its unique solution to the problem of high spreads for illiquid assets. Hundreds of millions of dollars are traded daily on the platform, with a total locked asset value of more than $5.9 billion.
What Is Uniswap?
Uniswap is a decentralised open-source protocol built on top of Ethereum and focused on the exchange of liquid and less liquid assets. Execution of trades through this protocol does not rely on traditional stock exchange order books or any centralised entities. The main advantage of decentralised exchanges is that they do not require identity verification (KYC) from their users.
Uniswap relies for its trades on a decentralised model in which market participants pool their free assets in so-called liquidity funds (LPs). Based on liquidity funds, this decentralised model creates an automatic pricing mechanism depending on the amount of assets available in the fund.
As Uniswap is a decentralised exchange, no central approval process is required to add a new token for trading. In principle, any ERC-20 token can be listed on Uniswap if it can be traded when a liquidity fund exists. This makes Uniswap the ideal place to trade start-ups and less liquid tokens.
How Does Uniswap Work?
There are currently two main types of exchanges in the cryptocurrency market: centralised and decentralised exchanges.
Centralised exchanges act as an intermediary for purchasing and selling cryptoassets. Most of these exchanges require Know-Your-Customer (KYC) verification, which means that users must verify their identity before making any trade. These exchanges also provide custody services. Therefore, many investors leave their assets directly on the stock exchange and are thus exposed to various risks.
On the other hand, decentralised stock exchanges like Uniswap have no central intermediary. All trades are carried out by traders with each other using smart contracts. The whole concept of a decentralised stock exchange is to replace the traditional stock exchange architecture with a design called Automated Market Maker (AMM).
Automated market makers (AMMs) are represented through smart contracts managing liquidity funds that traders can trade. AMM determines the price of any asset that is traded on a decentralised exchange based on the demand and supply for that asset using sophisticated computer algorithms.
Liquidity funds contain various types of tradable cryptoassets. Any investor can deposit, for example, Ethereum (ETH) and Uniswap (UNI) in the protocol and collect passive income from business fees every time someone exchanges ETH for UNI or UNI for ETH.
The Main Advantages of Uniswap
The main reasons for the growing popularity of the decentralised Uniswap exchange include:
- Non-custodial– Unlike centralised exchanges, Uniswap is based on the fact that the owners themselves have complete responsibility for managing their assets. Traders interact with the protocol through external wallets over which they have full control.
- Elimination of KYC: Uniswap is the ideal choice for those who do not want to verify on the stock exchanges and are trying to protect their privacy. Uniswap does not require any identification by ID card, driver’s licence or passport.
- Access to new cryptoassets – Since adding new tokens on Uniswap is not subject to any lengthy selection process, new cryptoassets with high growth potential will hit the stock exchange almost immediately.
- Low fees – Uniswap has significantly lower fees than most centralised exchange entities. Currently, the fees on the protocol are 0.3%. Although in reality, these fees are considerably higher, mainly due to gas fees in the Ethereum network. However, this problem could be solved in the future by the second layer protocols of Uniswap on the Ethereum network or the transition of Etherum to its upgraded version Ethereum 2.0.
- Friendly user interface – Uniswap is visually one of the most straightforward and most transparent stock exchanges on the market. Uniswap does not require the creation of orders or a complicated setup of trading orders.
Liquidity Funds and Liquidity Providers
Each Uniswap liquidity fund is a trading venue for a pair of tradable ERC-20 tokens. Whenever a new liquidity fund agreement is created, the initial value of the fund is 0 – there are no assets in the fund. Because Uniswap is an open-source protocol, anyone can become a liquidity provider on this protocol.
The main challenge of decentralised protocols, such as Uniswap, lies in liquidity crowdsourcing. Liquidity providers play an important role in these platforms by investing their assets in funds. Liquidity providers insert two types of tokens of equivalent value (e.g. ETH-ERC20 token or two ERC-20 tokens) into smart contracts, which manage liquidity funds.
In return, the smart contract issues a liquidity token to the liquidity provider, representing his share in the total liquidity fund. These liquidity tokens can be exchanged back for their share in the liquidity fund at any time.
Suppose traders want to trade a certain currency pair. They pay a fee for access to the liquidity fund, which is distributed among the liquidity providers based on their share in relation to the fund’s total value. As a result, liquidity providers collect passive income for depositing their assets in funds.
Pricing on Uniswap
Uniswap uses a tool called “Pricing Oracle” to obtain transaction data and aggregate prices for individual trading pairs. Pricing Oracle is a decentralised system fully resistant to price manipulation by external entities.
For example, if a trader wants to buy ETH for USDT, he must apply for access to the ETH/USDT liquidity fund to trade. It should be noted that the liquidity fund is designed to maintain equivalent ETH and USDT values and to ensure a constant balance. If a certain amount of ETH is withdrawn from the liquidity fund, this will cause a decrease in the total ETH supply in a given trading pair – which in turn will cause an increase in the price of ETH to USDT.
Pricing Oracles collects all this transaction data and aggregates it to obtain the price of each trading pair available on the Uniswap platform.
The following risks are also associated with the use of decentralised exchanges:
- Fraudulent projects – Although access to new assets with low market capitalization can sometimes be advantageous, it is not always the case. Since almost any ERC-20 token can reach Uniswap, there is a high probability of some fraudulent projects on the platform. That is why you need to be careful when trading new tokens and look for more information about the given token.
- Transaction failure: Transaction failure is one of the undesirable phenomena that accompanies decentralised exchanges. The transaction may fail, for example, if the gas fee related to the execution of the smart contract is set so low that it is simply unprofitable for the miners as they can decide not to process the transaction. The problem of transaction failure may also be related to a lack of liquidity in liquidity funds. However, this problem mainly affects tokens with a small market capitalization.
- Regulatory concerns: The potential risk of decentralised stock exchanges in the future may be posed by regulators who may try to make the use of decentralised stock exchanges illegal.
Native Network Token – UNI
The $UNI token is a native Uniswap protocol token that provides its holders with various benefits. For example, UNI token holders have the right to vote on changes to the protocol.
At the protocol’s inception, 1 billion tokens were issued, 60% of which are distributed to existing community members, and another 40% will be available to team members, investors, and other stakeholders over the next four years.
Uniswap is still a relatively new but innovative exchange protocol that allows virtually anyone with an Ethereum-enabled wallet to exchange tokens without interacting with central entities.
Although Uniswap still has its shortcomings and limitations, decentralised exchange technology may have a major impact on token exchange in the cryptocurrency world in the future.
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