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In 2016, Vitalik Buterin posted this under the Reddit forum r/ethereum; it was an idea proposing a decentralized exchange which would utilize a form of automated market maker. After losing his job at Siemens as a mechanical engineer, a man by the name of Hayden Adams decided to try his hand at a new project. Looking to sharpen his skills with a project, Adams set his sights on Buterin’s reddit post and ran with the idea. After numerous crypto conventions and various helping hands, November of 2018 rolled around, where Hayden Adams launched Uniswap, a decentralized cryptocurrency exchange that allows for users to trade their tokens. Now in 2022, Uniswap is the third most popular decentralized finance (DeFi) platform with a market dominance hovering around 27% and a trading volume of around $4 billion.
Traditionally, cryptocurrency exchanges have been carried out on centralized platforms and systems. These centralized exchanges act similarly to the stock market where a third-party lists all of the buy and sell orders, then matches buyers and sellers around a common price and volume. While centralized exchanges showcase to be successful with high volumes of trading daily, problems persist. Specifically, a centralized exchange may struggle with liquidity because transactions are only able to go through if a buyer and seller are able to be matched. Furthermore, some users have voiced their concerns about possible security breaches within a centralized system – one that contains all of the transactions’ information.
With growing concerns over security and liquidity, many people in the cryptocurrency space have taken interest in decentralized exchanges (DEX) – peer-to-peer marketplaces that use smart contracts to execute transactions. Introducing Uniswap.
Built on the Ethereum blockchain, Uniswap is a cryptocurrency trading platform that utilizes a set of protocols to carry out exchanges. In detail, the decentralized exchange uses an automated liquidity protocol, an autonomous trading mechanism that connects the users directly, without an intermediary. This eliminates the need for centralized exchanges and prioritizes censorship resistance and security. An automated liquidity protocol is in tandem with the Constant Product Marker Maker – a variant of the Automated Marker Maker. Additionally, the code for Uniswap is open source and available to anyone on GitHub.
Uniswap utilizes an automated liquidity protocol to achieve a marketplace where exchanges can take place anytime. To achieve this, an automated liquidity protocol first requires liquidity providers (LPs). Liquidity providers are those that will put their money and create a fund that can support the trades. Instead of exchanging funds between the buyer and seller, all exchanges will take from and put into the pool of money; thus as long as the pool exists, liquidity is possible at any time. In return, liquidity providers are given a liquidity token, which is a proof of their contribution and which records all of the trading fees owed to the liquidity provider. When a liquidity provider exits the pool, they receive an amount of the total trading fees which correspond to their contribution. For example, if a liquidity provider has a 5% stake within the pool, then they will get 5% of the trading fees when exiting. Afterwards, their liquidity token is destroyed.
The price of a token is determined by a formula: x*y = k. For the explanation, we will use an example using a DAI/ETH liquidity pool, where:
Here, if a user wants to exchange ETH for DAI, they would put ETH into the pool for DAI. This will increase the amount of ETH and decrease the amount of DAI in the pool. In the process of doing this, the price of ETH will drop and the price of DAI will rise because the product of these two numbers will still have to equal k. As a liquidity pool increases in size, the price changes will be less significant as there is more liquidity to work with.
In essence, exchanges using the liquidity pool will alter the prices of the corresponding tokens – whether significantly or significantly – because a constant value of k is required.
It is important to note that if a user wants to add a new ERC-20 token to the exchange, they will have to create a new liquidity pool for the token. They do this by adding equivalent amounts of the given ERC-20 token and another ERC-20 token into the pool. It is also worth to note that the prices of cryptocurrencies in Uniswap are kept in line with the rest of the market due to Arbitrage traders. Arbitrage is the process of taking advantage of the price differential of an individual asset across two separate markets. In the world of cryptocurrency, Arbitrage traders look for coins that are listed at different prices between marketplaces, and utilize that price difference by buying and selling quickly to make a profit. Eventually, the price of the coin realigns itself with the rest of the exchanges – this is the mechanism that maintains the price of Uniswap tokens with other markets.
Uniswap Tokens (UNI) are tokens issued by the company itself, and it gives holders a say in the company. For example, holders of UNI can vote in the development process of the platform and more. Currently, 15% of the total supply of UNI tokens have been distributed out to the community, and the rest is set to be distributed in the future or kept for employees.
While the idea of a decentralized exchange may seem appealing, it does come with its drawbacks. Firstly, there exists a sort of inefficiency within the automated liquidity protocol. Bigger liquidity pools have the capacity to support larger trading volumes and price ranges, yet oftentimes, typical exchanges seldom climb up and utilize the extent of the pool. Therefore, most cryptocurrency exchanges take place with a small portion of the liquidity pool, and the rest of it is left as idle assets. Secondly, liquidity providers may lose money in a process known as impermanent loss. Here, LPs lose money because the value of the coin appreciates, meaning their percentage and stake in the pool is now valued less.
While the world of cryptocurrency is still recovering from the crash of Terra and Luna, key figures in the space see this as an opportunity to improve the crypto ecosystem – such as Mary-Catherine Lader. As a former leader at BlackRock, Lader left Wall Street and dove headfirst into the world of crypto as the Chief Operating Officer at Uniswap. Additionally, Uniswap has been making pushes to hire more qualified individuals such as former Federal Reserve economist Gordon Liao. These are all under Uniswap’s move to connect traditional finance with the new world of cryptocurrency.
ABOUT THE WRITER
Daniel Shin is a contributor to Identity Review from the University of Southern California. Do you have information to share with Identity Review? Email us at firstname.lastname@example.org. Find us on Twitter.
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