DeFi101: What is Uniswap (UNI) and How Does It Work?

2021/06/10 07:05:43

Uniswap is the largest Decentralized Exchange (DEX) on Ethereum and is at the forefront of the DeFi ecosystem. Before Uniswap, centralized exchanges based on a traditional order-book mechanism dominated the market, while the “market makers” controlled the price of an asset when providing liquidity.

Since its launch, the total value locked (TVL) on Uniswap has surpassed $6.6 billion as of writing, making it one of the largest DEX in the entire DeFi ecosystem.

Source: DeFi Pulse (Uniswap TVL)

Uniswap brought together a unique architecture where the market makers no longer control the asset price when providing liquidity. Instead, the asset price is governed by a mathematical algorithm called automated market-making (AMM). Uniswap entirely sheds the concept of the traditional order-book mechanism, and the market makers merely provide liquidity in exchange for liquidity pool (LP) rewards.

It might sound overwhelming at first, but Uniswap is magically simple. This article will discuss everything about Uniswap, from its history to the inner mechanics, so you could understand this simple yet revolutionary DeFi product that provides a foundation for decentralized, non-custodial financial products.

Who Created Uniswap?

Uniswap was launched and deployed to the Ethereum mainnet by its creator Hayden Adams on November 2, 2018. Hayden was working as a Mechanical Engineer at Siemens, where he got laid off in 2017. Clueless about his future career, he found his way into the world of programmable money and discovered Ethereum.

His idea of Uniswap was inspired by Vitalik Buterin's Reddit post, where he discussed the idea of on-chain decentralized exchanges based on an algorithm used in prediction markets called automated market making. Hayden built a proof-of-concept based on Vitalik's idea, the same year when he got laid off, which was later presented in a talk at Devcon 3 conference in early November 2017.

Source: Uniswap (Hayden Adams with Vitalik at a blockchain conference in Hong Kong)

Hyden's idea was widely appreciated at the conference, and he later received a $50,000 grant from the Ethereum Foundation to keep working on the project. After one year of hard work and persistence, Uniswap was born and it took the market by storm. Interestingly, Hyden wanted to name it Unipeg, but Vitalik didn't like the name, so he called it Uniswap instead.

How Does Uniswap Work?

At its core, Uniswap is an Ethereum-based decentralized exchange with on-chain automated market maker protocol as its main feature. Uniswap uses the concept of liquidity pools instead of the traditional order-book mechanism used in almost every centralized exchange. To understand how Uniswap works, we first need to grasp the concept of automated market making and liquidity pools.

Automated Market Making (AMM) and Liquidity Pools

Automated market making, commonly referred to as AMM, sounds more complicated than it actually is. AMM is simply a mathematical algorithm to govern the price of an asset in a trust-less and decentralized way.

Centralized exchanges use an order-book mechanism where the market makers provide liquidity and control the price of assets through an order matching system. In this mechanism, the most recent price for which an asset was bought is considered the market price of that asset.

This process has two main limitations:

Slippage - If there are not enough market makers to provide liquidity for a particular asset, it increases slippage where the large volume orders drive the price of an asset up or down by a large magnitude that encourages price manipulation and higher volatility.

Lack of liquidity - Big market makers are only interested in a few assets with higher trading volume, and smaller projects always struggle to acquire an appropriate level of liquidity for healthy trading.

Uniswap democratizes this process through automated market making where big financial entities are no longer needed. Instead, anyone can become a market maker and provide liquidity for an asset pair. These market makers are called Liquidity Providers (LP).

The price of an asset is governed by a simple mathematical equation, X*Y=K. In an asset pair (like WBTC/ETH), X is the value of the first asset (WBTC), Y is the value of the second asset (ETH), and K is constant. No matter what the value of the first and second asset is, their product should always be equal to constant K. If the price of the first asset in the pair goes down, the equation adjusts by driving up the price of the second asset in the pair and vice versa.

Source: Uniswap (The anatomy of Uniswap)

The liquidity providers are rewarded with the fees generated when other users trade with their pools. Uniswap charges a fee of 0.3% per trade, which is the lowest compared to other players in the ecosystem. This fee goes directly to the liquidity providers according to their share of the liquidity pool.

The UNI token

Uniswap has a native governance token called UNI that allows holders to vote on governance-related activities like platform updates, fee structure, token distribution, etc. Uniswap didn't have any platform governance token until September 2020, and it was later created after facing intense competition from the rival DEX platform, SushiSwap.

SushiSwap is a fork of Uniswap, and it incentivized liquidity providers on Uniwap to reallocate their pool funds to SushiSwap by rewarding them with SUSHI tokens along with the portion of the transaction fees paid to the platform.

In response, Uniswap created 1 billion UNI tokens and distributed 150 million of them to anyone who used Uniswap's platform even once. Each user got 400 UNI tokens which at that time was worth a little over $1,000.

Wrapping Up

Uniswap is just over two years old and has gained significant amounts of traction since its launch. It had a very humble start with a $50,000 grant from the Ethereum Foundation, and a single developer experimenting with a proof-of-concept.

Fast forward to today, the 24-hour trading volume on Uniswap has surpassed $1 billion, generating over $3 million in fees every single day as of writing. Uniswap has also launched several updates for the platform in these two years, the biggest ones being V2 and V3, to introduce many different features and cater to the growing needs of users and liquidity providers.

KuCoin currently supports UNI trading, and at press time, UNI is standing at 22.73 USDT, down 2.12% over the last 24 hours.