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Exploring Uniswap - A Truly Decentralized Exchange

February 07, 2022

Exploring Uniswap - A Truly Decentralized Exchange

Many of you might be wondering - if cryptocurrencies are meant to foster decentralization, why then do we have centralized exchanges? Both centralized and their decentralized counterparts have their own benefits and demerits. 

Although most decentralized exchanges lack liquidity like their centralized counterparts - basically lots of money to foster faster buying and selling of cryptos - they make up for it in no management or arbitrary fees and less possibility of hacking or phishing.

Uniswap is one of the biggest decentralized exchanges, and it looks to solve the liquidity problem many DEXs have. Let's take a quick look at what Uniswap is and how it achieves this daunting task.

What is Uniswap?

Uniswap was built in 2018 by Hayden Adams on the Ethereum blockchain. Unlike most exchanges, Uniswap is fully decentralized, open-sourced, and made for the public good. 

No one receives any commission for trading on Uniswap, and the codes used to create it are open for anyone to replicate. Also, one of the major reasons for its prominence is that listing a coin on Uniswap is totally free, unlike most exchanges who charge huge sums before they list tokens. 

Also, Uniswap doesn't use the buyer - seller matching model to determine the price and execute trades as many exchanges do. Instead, it uses a simple mathematical equation and liquidity pool to achieve the same liquidity.

How does Uniswap work?

Uniswap operates using two smart contracts; the factory smart contract (used to list new ERC-20 tokens on Uniswap) and the Exchange Smart contracts (used to buy and sell tokens). 

To execute trades, Uniswap uses a liquidity pool ratio to influence the price of a token based on the laws of demand and supply. To begin the pool, any new listed coin has to be paired with a stablecoin or another ERC-20 token. The ratio starts at 1:1, meaning the same amount of the new coin and the stablecoin must be provided. 

The formula used for determining the price is x*y=k, 

where,

X = amount of new token

Y=  amount of paired token.

K is a constant value.

When the demand for the new token in the pool is high (many people are buying), the pool adjusts automatically, causing a higher token price. When the demand for the paired token (either stablecoin or the ERC-20 token) is high, the price of the new token reduces. 

Let's look at an example. John recently got to know about the AAVE project through Twitter. After making a 70% profit on the project, he decided it was time to sell. Since he wants to sell Aave on Uniswap to get Ether, he will need the AAVE/ETH pool. If he deposits his Aave (since the constant K in our formula above must be unchanged), the system will readjust the pool and give John the Ether equivalent of his Aave. 

What's Special About Uniswap?

As explained in the introduction, Uniswap solves the problems of liquidity faced by exchanges by using an automated liquidity protocol. This basically involves incentivizing people trading on the exchange to earn passively by providing liquidity to the pool. 

Users come together to create a fund which is in turn used to execute all trades that take place on the platform. By doing this, buyers do not need to wait for a seller of the same transaction before a deal is completed, and vice versa. Instead, as there is enough liquidity in the pool, transactions can be carried out at any time. 

Liquidity providers receive a token that shows the value of their liquidity in relation to the whole pool. So if you invest $100,000 in a pool that has a total of $1,000,000, you'll get a token for 10% of the pool. 

For every buying and selling on the Uniswap platform, a fee of 0.3% is charged and sent to a liquidity reserve. Any provider who wants to exit the pool will receive their token's equivalent of the pool, and the token will be destroyed. 

Part of the Uniswap V.2 upgrade involves a new community-decided fee of 0.05% out of the liquidity providers' fees to finance the future development of the Uniswap platform. The fee is turned off for now, but Liquidity providers will start earning 0.25% whenever it comes on, with the rest going to the upgrade fund. 

How To Buy Tokens On Uniswap?

Buying Tokens on Uniswap is straightforward, but you'll need to hold Ether on your wallet. 

  1. Go to Uniswap.

  2. Connect your decentralized wallet like MetaMask. 

  3. On the home page, you'll see a pair, and most times, ETH is automatically on the top pair. 

  4. If not, choose ETH up and click the 'Select a token' tab on the lower pair.

  5. Search for the token you want to buy, e.g., $LINK.

  6. Choose the dollar equivalent of the $ETH you want to spend, and the system will automatically display the token quantity (in this case, $LINK); you will see the amount of $ZCX you will receive. Eg: 0.43 $ETH → 492.079 $ZCX. Click Swap.

Pros and Cons of Uniswap

Pros

  1. Uniswap has no central authority; hence you don't need any KYC process to get started. Setting up your transaction environment is as seamless as it can be. 

  2. You are in charge of your private keys, and except you buy a bad project with loopholes on its smart contract, no third party can steal your funds in the liquidity pool. 

  3. New ERC-20 projects will find Uniswap to be a benefit. There are no huge fees needed to launch your project on the platform, neither is there any lengthy listing process.

  4. As investors, Uniswap's liquidity pool gives the chance to earn passively with returns much more than traditional financial structures will give. 

Cons

  1. There is an emergence of Cross-chain platforms that do way more than Uniswap does. This is a huge threat to Uniswap's model.

  2. Since Uniswap is open-sourced, other platforms can copy their design and pull a fast one on them. We've seen it with sushiswap, and though the Uniswap V.3 would need some form of agreement, it doesn't look like it would deter forking of the platform.

Conclusion

Uniswap believes they can muster the trading volume of too centralized exchanges like Binance and Coinbase without compromising the tenets of decentralization. That seems like a very lofty goal, but with the success they've achieved so far, who says it's not possible? What do you think?

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