Uniswap

What is the Uniswap liquidity protocol?

This is a decentralized trading protocol created by Hayden Adams, a former mechanical engineer at Siemens. Uniswap is one of the best known DeFi applications and consistently ranks among the top 10 crypto projects by market cap.

Uniswap basics

Uniswap is a protocol for swapping ERC 20-based crypto assets. In addition, it has its own token UNI. The platform was launched in 2018 by Hayden Adams, and it was based on the Ethereum network, which makes Uniswap compatible with all Ethereum-supporting coins and wallets.

Unlike most services, which have transaction fees, the Uniswap protocol claims to work as a public good, enabling the crypto community to trade coins with zero commission.

Users can exchange coins on Uniswap without the need for third-party interference to process the transfer within this ecosystem. In addition, crypto holders can lend their tokens to liquidity pools and earn income in return.

UNI token

In September 2020, Uniswap launched its governance token, UNI, whose market cap has exceeded $17 bln.

Users who have tried Uniswap v1 or v2 are eligible to claim 400 UNI. As a governance token, UNI enables holders a right to vote on changes in the Uniswap protocol.

How does Uniswap operate?

Uniswap supports a system known as Constant Product Market Maker, which is an alternative to automated market makers (AMMs).

Automated market makers are smart contracts powering liquidity reserves (or liquidity pools) that users can trade against. These reserves are supplied by liquidity providers in pairs of tokens. As a liquidity provider, you deposit an equivalent value of two coins to a respective pool. For instance, to an ETH/DAI liquidity pool you need to provide the same amount of both coins in USD equivalent.

In exchange for their ETH and DAI, a liquidity provider will receive liquidity provider tokens, or LP tokens, which will be swapped back for ETH and DAI when withdrawing tokens from the pool. Liquidity providers are rewarded by a portion of fees charged on each swap deal in the pool.

On Uniswap, the “constant product” formula is used, expressed as x * y = k. The formula states that trades must not change the product (k) of a pair’s reserve balances (x and y, respectively).

It is important to note that it is impossible to scale this model linearly. In effect, the larger the order is, the more it shifts the balance between x and y. This means that larger orders become exponentially more expensive compared to smaller orders, making slippage bigger. It also means that the larger a liquidity pool is, the easier it is to operate large orders as a shift between coins x and y is smaller.

Is Uniswap secure?

Although Uniswap is a popular DeFi protocol, you should approach it with care, as no DEX could protect you from investing in toxic coins that could lose their value at any point. Technically, anyone can add any coin to a decentralized exchange, like Uniswap, which creates opportunities for fraud.

For instance, fraudsters could create a token with a name similar to a popular coin, thereby raising demand for it. Once the price has reached a certain level, the fraudsters would unload the coin’s supply, driving down its value to zero.

Therefore, users should be careful about any coin they buy and do thorough research before investing in any coin on Uniswap or elsewhere.