Summary
The Uniswap protocol is a set of computer programs that run on the Ethereum blockchain and allows tokens to be swapped in a decentralized manner. The protocol has “unicorns” as its tag (as seen in the logo).
Traders can trade Ethereum tokens on Uniswap without having to credit anyone with their funds. Meanwhile, anyone can lend their cryptocurrencies to private reserves called liquidity pools. In exchange for providing money to these pools, they earn fees.
How does the Uniswap protocol convert one token to another? What do you need to use Uniswap? This is what we will learn about in this article.
the introduction
Centralized trading platforms have been a mainstay of the cryptocurrency market for several years, as they offer fast settlement lead times, high trading volume, and constantly improving liquidity. However, there are parallel platforms that are built in the form of non-trust-based protocols. Decentralized exchanges (DEX) do not require intermediaries or custodians of your funds to facilitate trading.
Due to the inherent limitations of blockchain technology, it has been difficult to build decentralized trading platforms that truly compete with their centralized counterparts. Most decentralized trading platforms could improve in terms of performance and user experience.
Many developers have been thinking of new ways to create a decentralized trading platform, and Uniswap has been at the forefront of these platforms. Understanding how Uniswap works may be more difficult than understanding a traditional decentralized trading platform, but we will see here that this model offers some attractive advantages.
As a result of this innovation, Uniswap has become one of the most successful projects and is part of the decentralized finance (DeFi) movement.
Let's see what the Uniswap protocol is, how it works, and how you can swap tokens on it simply using an Ethereum wallet.
What is Uniswap?
Uniswap is a decentralized trading platform protocol built on Ethereum. To be more precise, it is an automated liquidity protocol. There is no order list or any other central party required to place trades. Uniswap allows users to trade without intermediaries, with a high degree of decentralization and resistance to censorship.
Uniswap is open source, and you can check it out on Uniswap GitHub.
Okay, but how do trades take place without an order list? Uniswap operates on a model that involves liquidity providers creating liquidity pools. This system provides a decentralized pricing mechanism that essentially reduces the depth of the order list, and we will go into more detail about how it works later. For now, just note that users can easily swap between ERC-20 tokens without needing an order list.
Since the Uniswap protocol is decentralized, there is no listing process, but any ERC-20 token can be launched as long as there is a liquidity pool available to traders. As a result, Uniswap does not charge any listing fees either, i.e. the Uniswap protocol acts, to some extent, as a publicly available commodity.
Hayden Adams created the Uniswap protocol in 2018, but the underlying technology that inspired its implementation was first described by Ethereum co-founder Vitalik Buterin.
How does Uniswap work?
Uniswap leaves behind the traditional structure of digital trading in that it does not have an order list. It works on a design called the Fixed Products Market Maker, which is a variation of the Automated Market Maker (AMM) model.
An automated market maker is a smart contract that holds liquidity reserves (or liquidity pools) with which traders can trade. These reserves are funded by liquidity providers, and a liquidity provider can be anyone who deposits an equivalent value of two tokens into the liquidity pool. In return, traders pay a fee to the pool which is then distributed to liquidity providers according to their stake in the pool. Below we will explain this mechanism of action in more detail.
Liquidity providers create a market by depositing an equivalent value of two tokens, this can be either ETH and an ERC-20 token, or two ERC-20 tokens. These pools usually consist of stablecoins such as DAI, USDC or USDT but this is not a requirement. In return, liquidity providers receive “liquidity tokens,” which represent their share of the entire liquidity pool. These liquidity tokens can be redeemed for the stake they represent in the pool.
Let's look at the ETH/USDT liquidity pool. We will call the ETH portion of the pool x and call the USDT portion of the pool y. Uniswap takes these two quantities and multiplies the value of one by the other, to calculate the total liquidity in the pool, we will call this k. The basic idea behind Uniswap is that k should remain constant, which means that the total liquidity in the pool is constant. So, the equation for the total liquidity in the pool is:
x * y = kSo, what happens when someone wants to place a trade?
Let's say Alice buys 1 ETH for 300 USDT using the ETH/USDT liquidity pool. By doing this, it increases the USDT portion of the liquidity pool and reduces the ETH portion of the pool, which effectively means that the price of ETH rises. Why? Because after this transaction, the amount of ETH in the pool decreases, while we know that the total liquidity (k) should remain constant. This mechanism determines pricing. Ultimately, the price paid for ETH depends on how much a particular trade changes the ratio between x and y.
It is worth noting that this model is not measured on a linear scale. In fact, the larger the demand, the more it helps shift the balance between x and y. This means that larger orders become significantly more expensive compared to smaller orders, resulting in larger and larger amounts of slippage. This also means that the larger the liquidity pool, the easier it is to process large orders. Why? Because in this case the transformation between x and y is smaller.
Uniswap v3
The technology behind Uniswap has seen many advancements so far, and if you've used Uniswap then you've probably used Uniswap v2. However, there are always new improvements being implemented, and below we will review the most impactful updates that Uniswap v3 offers.
Capital efficiency
One of the most important changes that Uniswap v3 brings relates to capital efficiency. Most automated market maker models lack capital efficiency - that is, most of the money in them at any given time is not in use, due to an inherent feature of the x * y = k model we discussed earlier. In a simplified way, the more liquidity there is in the pool, the greater the volume of orders the system can respond to in a larger price range.
However, liquidity providers in these pools mainly provide liquidity in a price curve (range) between 0 and infinity. All that capital is sitting there saved in the event that a scenario occurs where one of the assets in the pool goes fivefold, tenfold, or hundredfold.
If this happens, those idle assets ensure that there is still liquidity remaining in that part of the price curve. This means that only a small portion of the liquidity in the pool sits where most of the trading occurs.
For example, Uniswap currently has about $5 billion of liquidity locked up, while its trading volume does not exceed $1 billion per day. You might think that this is not a convenient and efficient way to work, and the Uniswap team seems to agree with that, hence, Uniswap v3 addresses this issue.
Liquidity providers can now define custom price ranges they want to provide liquidity to. This would lead to more concentrated liquidity in the price range where most trading activity occurs.
That is, Uniswap v3 is a fairly elementary way of creating an on-chain order list on the Ethereum platform, where market makers can decide to offer liquidity at the price ranges they specify. It should be noted that this change favors professional market makers over participants in low-volume trades. The appeal of the automated market maker model is that anyone can provide liquidity and put their money to work.
However, with this additional layer of complexity, “lazy” liquidity providers will earn much less in trading fees than their professional colleagues who are constantly improving their strategy. At the same time, it's not hard to imagine aggregators like yearn.finance providing small liquidity providers a way to remain somewhat competitive in this environment.
Uniswap's liquidity provider tokens are non-tradable
We now understand that each liquidity provider's position in Uniswap is unique because each depositor can set their own price range. This means that Uniswap liquidity provider trades are no longer interchangeable. As a result, every liquidity provider trade is now represented by a non-fungible token (NFT).
One of the advantages of representing a Uniswap liquidity provider transaction with a fungible token is how it can be used in other parts of the DeFi ecosystem. Uniswap v2 liquidity provider tokens can be deposited in Aave or MakerDAO as collateral. But this is no longer the case with the third version since each deal is unique. However, this lack of compatibility can be addressed by using new types of derivative products.
Uniswap on Layer 2 solutions
Transaction fees on Ethereum have skyrocketed in the past year, making Uniswap economically unviable for many small users.
Uniswap v3 will also be used on a layer 2 network scaling solution called Optimistic Rollup, which is a great way to scale smart contracts while still enjoying the security of the Ethereum network. This use should result in a significant increase in transaction volume and significantly lower fees for users.
What is a non-permanent loss?
As we discussed, liquidity providers earn fees for providing liquidity to traders who can swap between tokens. Is there something else liquidity providers should be aware of? Yes, there is an effect called impermanent loss.
Let's say Alice deposits 1 ETH and 100 USDT into the Uniswap pool. Since the pair of tokens must have equal value, this means that the price of ETH is 100 USDT. At the same time, there is a total of 10 ETH and 1,000 USDT in the pool – the rest is funded by other liquidity providers like Alice. This means that Alice has a 10% share of this pool, and the total liquidity in this case (k) is 10,000.
What happens if ETH price rises to 400 USDT? Remember that the total liquidity in the pool must remain constant. If ETH is now equal to 400 USDT, this means that the ratio between the amount of ETH and the amount of USDT in the pool has changed, since, in fact, there are 5 ETH and 2,000 USDT in the pool now. Why? Arbitrage traders will add USDT to the pool and remove ETH from it until the ratio reflects the correct value of the price, which is why it is important to understand that k is a constant.
So, Alice decides to withdraw her money and get 10% of the pool according to her share. As a result, she gets 0.5 ETH and 200 USDT, for a total of 400 USDT, it seems she made a good profit. But wait, what would have happened if she hadn't put her money into the pool? It will have 1 ETH and 100 USDT, for a total of 500 USDT.
In fact, Alice would have been better off holding her cryptocurrencies rather than depositing them in the Uniswap pool. In this case, the impermanent loss is essentially the opportunity cost of accumulating a token whose price increases. This just means that by depositing funds into Uniswap in the hope of earning fees, Alice may be missing out on other opportunities.
Note that this effect works regardless of the direction in which the price changes from the time of deposit. What does this mean? If the price of ETH declines compared to the time of deposit, losses may also magnify. If you want a more technical explanation of this, you can check out this article.
But why is the loss not permanent? Because if the price of tokens in the pool returns to the first price when they were added to the pool, the effect is mitigated, and also since liquidity providers earn fees, the loss may be offset over time. However, liquidity providers need to be aware of this before adding funds to a pool.
How does Uniswap make money?
In fact, it is not profitable. Uniswap is a decentralized protocol backed by Paradigm (a digital hedge fund). All fees go to the liquidity providers, and none of the founders receive a share of the trades made through the protocol.
Currently, the transaction fee paid to liquidity providers is 0.3% per trade. This fee is automatically added to the liquidity pool, but can be refunded by liquidity providers at any time. Fees are distributed according to the share of each liquidity provider in the pool.
A portion of the fee may be allocated to developing Uniswap in the future. The Uniswap team has already released an improved version of the protocol called Uniswap v2.
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How to use Uniswap
Uniswap is an open source protocol, meaning anyone can create a front-end application for it, but the most commonly used are https://app.uniswap.org or https://uniswap.exchange.
Go to the Uniswap protocol user interface.
Link your wallet to the protocol, you can use MetaMask, Trust wallet or any other wallet supported by Ethereum.
Select the token you wish to trade.
Select the token you wish to trade to.
Click Swap.
Review the transaction in the pop-up window that will appear.
Confirm the transaction request in your wallet.
Wait for the transaction to be confirmed on the Ethereum blockchain. You can monitor the transaction status at https://etherscan.io/.
Uniswap token (UNI)
UNI is the native token of the Uniswap protocol, and gives its holders governance rights, which means UNI holders can vote on changes to the protocol. We previously discussed how the protocol actually functioned as a publicly available commodity, and the UNI token solidifies this idea.
One billion UNI tokens were minted when the protocol was created, 60% of which was distributed to existing Uniswap community members, while 40% will be available to team members, investors and advisors over four years.
Part of the distribution to community members occurs via liquidity mining, which means that UNI tokens will be distributed to those providing liquidity to the following Uniswap pools:
ETH/USDT
ETH/USDC
ETH/DAI
ETH/WBTC
But who are the Uniswap community members? Well, they are all Ethereum addresses that interacted with Uniswap contracts. Below we will see how you can claim UNI tokens.
How to claim Uniswap (UNI) tokens
If you have used Uniswap, you can probably claim 400 UNI tokens for each address you have used the Uniswap protocol with. To claim tokens:
Go to https://app.uniswap.org/.
Link the protocol to the wallet you have previously used Uniswap with.
Click on “Claim UNI Tokens”.
Confirm the transaction in your wallet (you can check the current transfer rate on the EthScan Gas Tracker).
Congratulations, you have become a UNI token owner!
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How to buy UNI tokens on Binance
In order to purchase UNI tokens, you need to exchange your local currency or digital currency using the Binance trading platform view. You cannot use a debit/credit card to purchase UNI tokens directly. Available trading pairs include BNB, BTC, BUSD, USDT, or EUR.
If you want to buy UNI tokens using cryptocurrencies, you can transfer the coins to your instant wallet or buy some coins. We recommend using the BUSD option, as the price of this currency is stable. You can buy BUSD using your card by going to the [Buy Digital Currencies] page. Enter the amount you wish to purchase, then click [Continue] to enter your card information.
Once you receive your cryptocurrency, go to the trading platform, then select the UNI trading pair you wish to trade. You can change the trading pair by clicking on the current market pair at the top left.
In the search bar, type your chosen pair. In this example, we need UNI/BUSD.
Now you can create an order to buy UNI tokens. The quickest way is to use a market order which gives you the current price in the spot market. You can also specify a limit order or a limit stop order if you want to buy at a specific price or at a better price.
To create a market order, go to the right side of the trading platform, then click [Instant]. But make sure to select [Market] in the Order Type under the [Buy] tab, then type the amount in BUSD you wish to trade. Finally, click [BUY UNI] to complete the order.
How to sell UNI tokens on Binance
The UNI selling process is similar to the buying process. First, make sure that your UNI tokens are in your Binance spot wallet. If you haven't deposited your tokens, go to the [Supported Local Currency & Instant Wallet] page, then search for UNI. Click [Deposit] to view detailed instructions on how to convert your UNI tokens. You can also read the guide on how to deposit on Binance available on our website for further assistance.
After successfully depositing your UNI tokens, open the trading platform view and select the UNI trading pair you wish to trade. The following image shows UNI/BTC trading.
Use the search bar to select the exchange pair of your choice. In this case, click [UNI/BTC].
To sell your UNI tokens at the current market price, go to the right side of the screen. Click [Instant], then select the order type as [Market] under the [Sell] tab. Enter the amount of UNI you wish to sell, then click [Sell UNI].
Concluding thoughts
Uniswap is an innovative trading protocol built on the Ethereum platform, allowing anyone with an Ethereum wallet to trade tokens without the intervention of any central party.
While this technology has its limitations, it could have some interesting implications for the future of non-trust-based token swapping. Once Ethereum 2.0 scalability solutions are up and running on the network, Uniswap will likely benefit from them as well.