July 25

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What is Uniswap? A Complete Beginner’s Guide

Ilir Salihi

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Uniswap first launched in late 2018, and rapidly rose to become one of the most highly valued tokens on the digital currency market. So what is Uniswap, why is it so popular, and is it a good investment?

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The Origin of Uniswap

To understand Uniswap’s success, it’s helpful to understand some background about the cryptocurrency ecosystem.

Centralized exchanges like Coinbase became the main gatekeepers to the world of cryptocurrency, but in many ways, they were directly contrary to the original aim of cryptocurrency. Cryptocurrency was first developed to offer an alternative to payment systems controlled by trusted third parties like banks who sometimes abuse their power.

Most of the major problems in the cryptocurrency space were caused by centralized exchange; Mt. Gox, the first major Bitcoin exchange, “lost” $460 million worth of user funds in 2014. Let’s not even talk about how much the 850,000 bitcoins would be worth today. 

Some centralized exchanges simply disappeared with user funds. Others were hacked. Millions of dollars of user funds were frozen after the CEO of a cryptocurrency exchange died. 

These kinds of problems led Ethereum found Vitalik Buterin to comment:

“I definitely hope centralized exchanges go burn in hell as much as possible.” 

Decentralized exchanges had a number of clear advantages. Each user had total control over their funds, so there was no risk of fraud. It also enables people worldwide to participate in markets, bypassing ID checks and regulations. 

But decentralized exchanges faced a number of challenges. That’s where Uniswap came in. 

Related: Free Guide Reveals How to Buy Uniswap (UNI) with Your 401(k)

What is Uniswap?

Uniswap is actually a protocol which generates smart contracts that enable buyers and sellers of cryptocurrencies and tokens to trade with each other. It was first developed in 2018 by Hayden Adams based on a concept proposed by Vitalik Buterin called an automatic market maker. 

Let’s look at the main components that make Uniswap tick. 

Automatic Market Makers

Automatic market makers (AMMs) are one of the essential components of Uniswap. An AMM is a method which replaces the order books used by traditional exchanges. With an order book, prices are determined by how much buyers and sellers are willing to buy or sell an asset for— a bid/ask spread. 

An AMM uses a mathematical algorithm to buy and sell tokens automatically, adjusting prices with each purchase or sale. This means that people transact directly with each other, with all transactions mediated by smart contracts. 

This way, there is no possibility to steal user funds in an exit scam or to have your account frozen by a totalitarian government. It also reduces fraud, like faking trade volume, which is very common with centralized exchanges. 

The Uniswap Factory

The Uniswap factory is a program which generates AMMs. All AMMs on Uniswap manage the trading token pairs. If an ERC-20 token is not currently available on Uniswap, anyone can create a new AMM for it using the factory.

The factory also includes a directory of all of the available trading pairs. 

What is Uniswap (UNI)? Complete beginner's guide

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Liquidity Providers

AMMs sound great, but smart contracts can’t just pull themselves up by the bootstraps and find money on their own. Someone has to fund them.

That’s the job of liquidity providers. To create an AMM, a liquidity provider must provide an amount of Ether (ETH) and whatever ERC-20 token the AMM will trade. 

In exchange for offering up their money, liquidity providers are rewarded with a share of the transaction fees. They also receive liquidity tokens, which can be used to redeem their share of the pool. 

Arbitrageurs

Arbitrageurs keep AMMs in line with the wider cryptocurrency market. 

As the price of the market moves, price differences appear between different exchanges. This means there is an opportunity to make money by buying tokens on one exchange and moving it to another. 

Arbitrageurs watch the market and move to buy and sell, keeping prices in line with prices on other exchanges.

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Uniswap Governance Token

Uniswap released a token (UNI) in September of 2020. This move was in response to a competitor called Sushiswap which was also issuing a governance token.

Governance tokens allow those who hold them to vote on the development of the platform. They can also be used for liquidity mining, which allows liquidity providers to earn additional profits.

There is a total supply of 1 billion UNI tokens scheduled for release by 2024. 60% of these are being distributed to the community of Uniswap users, while 40% are reserved for the development team, investors, and advisors. 

When the original supply of 1 billion UNI is distributed, Uniswap will continue to mint new UNI in order to continue providing rewards to liquidity providers. The new tokens generated will amount to a 2% annual inflation rate. 

Related: Free Guide Reveals How to Buy Uniswap (UNI) with Your 401(k)

Potential Problems

A free and open financial market. It all sounds pretty good, right? But what’s the catch?

Impermanent Loss

Many liquidity providers end up losing money on Uniswap due to impermanent loss. “Impermanent loss” is a term that describes losses resulting from rapid price changes in an exchange contract.

For example, if you deposit ETH and DAI into a contract and the price of ETH suddenly goes up, arbitrageurs will come and buy up the cheap ETH, increasing the price. The result is that your percentage share of the pool now has less dollar value than when you deposited it.

Ideally, the trade fees you earn would cover your losses, but in many cases it doesn’t work out that way. This means that you need a good strategy to make money on Uniswap as a liquidity provider.

Married to Ethereum

One issue with Uniswap is that it runs on the Ethereum network, which is struggling to keep up with its own success. As interest in cryptocurrency surged in early 2021, so did fees on the Ethereum network, which also meant higher fees on Uniswap. 

The development of layer 2 solutions has eased some of this pressure, but these solutions are still very much under development.

Uniswap only trades ERC-20 tokens at the moment, so its future success is very much tied to Ethereum’s success.

Related: Buy Uniswap (UNI) on Coinbase.com Today

Centralization

Some critics view Uniswap as too centralized. Issuing the UNI token was partly in response to Sushiswap, a platform which is seen as more “community oriented.” 

Uniswap has considerable venture capital backing, and some critics think the development team is serving the interests of investors rather than users. The voting features of the UNI token were meant to allay some of these concerns, but since a large percentage of them are going to those venture capital investors, it’s not an ideal solution. 

Bugs

So far, Uniswap has not fallen victim to any major hacks. However, it does suffer from some bugs that negatively affect user experience. This is fairly common with decentralized applications.

One such bug causes new token listings to appear as “Unknown” rather than listing their name.  It’s kind of hard to trade if you don’t know what you’re trading. 

This is not a major issue, but it’s typical of the kind of challenges facing DeFi protocols. 

Regulation

UNI saw a selloff due to regulatory concerns after BitMEX founders faced criminal charges for evading money laundering regulations in 2020. This is a good example of why there is so much concern about decentralization in cryptocurrency markets.

Regulators are not too happy about unlicensed exchanges doing billions of dollars in daily trade volume. Some investors worry that regulators could also come after the Uniswap development team. 

Of course, the fact is that regulators can’t shut down Uniswap. However, the protocol is still highly dependent on the development team, so if they face legal action it could negatively impact the exchange. 

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Uniswap’s Future

Uniswap has been growing fast, and it doesn’t look to be slowing down. There are quite a few people making money on Uniswap, and they may have an interest in having a say in its future. This could generate strong demand for UNI going forward.

At the same time, the fact that UNI will turn into an inflationary token in the future may not be attractive to some investors. Liquidity providers may prefer to sell their UNI tokens and exchange them immediately for non-inflationary tokens.

Uniswap is an open source project, so anyone can copy its code. It’s facing hot competition from Sushi Swap and Pancake Swap, along with many others. However, it currently has a firm hold on the top spot among Ethereum-based decentralized exchanges, and it has plenty of  funding to try to hold onto that spot.

As long as the Ethereum ecosystem continues to grow, it’s likely that Uniswap will continue to grow with it.

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About the Author

Ilir writes about personal finance, entrepreneurship, and digital marketing. When he's not creating content online, he's spending time with his family in Washington, DC.

Ilir Salihi


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