What is Uniswap – A Beginner’s Guide
By: Alexander Reed | Last updated: 2/6/24
Uniswap is a decentralized exchange that allows anyone to trade Ethereum and Ethereum tokens directly without the use of a middleman. This guide explains how Uniswap does that, how it is different from traditional exchanges and also what is UNI – Uniswap’s token.
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What is Uniswap Summary
Uniswap is a permissionless, decentralized exchange (Dex in short) that allows users to trade various ERC-20 tokens directly, meaning without a privately controlled body between them.
DEXs such as Uniswap are able to do what traditional exchanges do, such as maintain liquidity and determine prices, via sets of automated rules and algorithms defined within smart contracts.
In addition, Uniswap is also the issuer of UNI – an ERC-20 token which functions as a governance token, allowing holders to vote on development decisions. While not originally designed as a currency, UNI is often at the top of the cryptocurrency list.
That’s Uniswap in a nutshell. If you want a more in-depth explanation of Uniswap, keep on reading, here’s what I’ll cover:
- Traditional Exchanges Vs. DEXs
- What is DEX
- Uniswap Overview
- How to Use Uniswap
- What is the UNI Token
- Conclusion
1. Traditional Exchanges Vs. DEXs
Uniswap is a DEX, so before we get familiar with Uniswap, we first need to understand what a DEX is and how it is different from traditional exchanges, such as Kraken or Bitstamp.
To begin with, traditional exchanges are centralized, meaning they are owned by a company that has complete control over the exchange and the computers that run it.
Traditional exchanges are also regulated by KYC laws, which is an abbreviation for ‘Know Your Customer’. These laws require each new customer to provide extensive personal information, including your home address and tax ID numbers before you can begin trading on the exchange.
Additionally, in order to trade on a traditional exchange, users need to deposit money on the exchange, basically giving the exchange control over their funds.
On a traditional exchange, when users want to buy or sell a certain cryptocurrency they submit a “Buy” or “Sell” order. All of these orders are recorded in the exchange’s order book. Once there’s a match between a buyer and a seller, a trade is conducted.
So this is how a traditional, centralized exchange works. If you want to learn more about exchanges and trading, you can check out our Bitcoin trading guide. Now let’s talk about decentralized exchanges, also known as DEXs.
2. Decentralized Exchanges
DEXs are part of the decentralized finance ecosystem. Decentralized finance, or DeFi for short, is a term given to traditional financial services such as exchanges, lending services, and insurance, that have been decentralized through the use of Blockchain technology.
Now, unlike a traditional exchange that requires a controlling company and centralized servers to operate, A DEX consists of a set of smart contracts deployed on a blockchain. In simple terms, it’s a set of automated rules that are executed by a network of independent computers without any central entity controlling it.
Since DEXs aren’t controlled by anyone, they can’t be regulated and are in fact open to everyone. When using a DEX there’s no need to open an account, or go through an identification process where you’d have to supply your personal information.
Additionally DEXs allow users to trade directly from their own wallets allowing them to keep full control over their funds.
Price discovery
A key difference a DEX has from a traditional exchange is in the way transactions are conducted and how price is determined.
As I’ve mentioned earlier, in a traditional exchange buyers and sellers set their price expectations as “Buy” and “Sell” orders inside the order book.
The more buyers and sellers an exchange has, the larger its order book and the more “liquid” the exchange is said to be. In other words, it’s easier to find a buyer and a seller that agree on a price and make a trade.
Imagine there are only 2 buyers and 2 sellers on a certain exchange. It would be very hard for any trade to get executed, since it’s unlikely to find two people who would agree on a price.
Without liquidity the exchange is practically dead since no trades can be conducted. It’s the same as having a shopping mall with very few stores and customers. There’s not a lot of business that will be done there.
In fact, liquidity is such an important criteria to determine the quality of an exchange, that some exchanges use external services called “market makers” that are willing to buy and sell at all times, creating constant liquidity for the exchange.
Liquidity mining pools
DEXs don’t store any user funds and have no order book. Liquidity on DEXs is created through liquidity pools.
Liquidity pools are a shared pot of funds deposited by the general public, and DEXs use liquidity pools in order to fulfill “buy” and “sell” orders.
People who deposit funds in liquidity pools are known as liquidity providers or LPs. In exchange for the locked funds, LPs receive a part of the DEX’s trading fees in a process known as liquidity mining.
Now that we’ve covered the differences in how liquidity is provided between traditional and decentralized exchanges, let’s see how the price of a certain coin is determined.
On a traditional exchange, when a seller and buyer reach an agreement through matching orders in the exchange order book, a trade is conducted. At that point the price of the coin is determined until another trade is executed at a different price. In other words, the price of the most recent trade is considered the current price on the exchange.
AMMs explained
A DEX, on the other hand, doesn’t have an order book. Users don’t trade with one another, they trade within a liquidity pool; Instead of using the last trade to determine the price, a mathematical formula is used. This formula, or algorithm, is called an Automated Market Maker or AMM for short.
Uniswap, for example, uses an AMM called “Constant Product Market Maker Model” to determine the price of coins on its exchange. This AMM follows a simple formula of X times Y equals K.
This means that when trading, for example, Ether for DAI the amount of Ether available times the amount of DAI available on Uniswap’s Ether/DAI liquidity pool should always equal a constant number.
Let’s break this down a bit further:
Imagine there are 10 ETH and 10,000 DAI on a certain liquidity pool. As we can see, using the AMM model this means that the number of ETH times the number of DAI equals 100,000, this is our constant K.
If I were to buy 1 ETH, this will reduce the number of ETH in the pool to 9. Now the question remains, how many DAI will this cost.
Well, the way to calculate this is to take our constant of 100,000 and divide it by the new number of ETH, 9. This would give us the new number of DAI required in our pool – 11,111. Meaning we need to deposit around 1,111 DAI to buy one ETH.
As you can see the price is determined by how much of a certain token you want to buy, not by how much someone else wants to get for it.
By using the “Constant Product Market Maker Model” algorithm, liquidity is kept without the need for external market makers, no matter how large the order size or how tiny the liquidity pool. This model makes it infinitely expensive to consume the whole amount of a certain coin, putting a damper on larger orders.
For example, In our previous exercise, if I wanted to buy 9 ETH it would cost me 90,000 DAI to maintain the 100,000 constant, making each ETH cost 10,000 DAI instead of the 1,111 DAI it would cost to buy only 1 ETH.
Of course there are other DEXs with different AMM algorithms than the one used on Uniswap, but that conversation goes beyond the scope of this guide.
3. Uniswap Overview
Now that we’ve covered DEXs we can focus on Uniswap more in depth.
Uniswap is a DEX built on top of the Ethereum network infrastructure. It’s a set of automated rules used for trading ERC-20 tokens, which is a term given to a certain standard of Ethereum tokens.
Uniswap is the most popular decentralized application, or DAPP, on the Ethereum platform with hundreds of thousands of users trading on it each week. Additionally Uniswap is one of the most forked projects in the DeFi space, meaning people use its code to build additional applications.
The first version of Uniswap started out in November of 2018. Uniswap’s V1 allowed trading of any ERC-20 token to Ether and back. In May of 2020 V2 was released and the trading of ERC-20 tokens directly between one another without first having to trade with Ether became available.
In May of 2021, V3 was released allowing a more effective use of capital to whoever decides to supply liquidity to Uniswap. In other words you can squeeze more “juice” out of the money you deposit in the liquidity pool.
V4 is in the process of being released, and the draft code was released to the public in late 2023.
4. Using Uniswap
Now that you know what Uniswap is, it’s time to learn how you can use it.
To use Uniswap, all you need is an Ethereum wallet like Metamask which can interact with other Ethereum applications. Here’s how you can use Uniswap in 3 simple steps:
- Install Metamask on your browser
- Head to Uniswap.org and click on ‘Connect wallet’
- Choose Metamask
That’s it! Now you can start trading any Ethereum ERC-20 token that is listed on Uniswap.
Slippage
Keep in mind that since there are many people conducting trades on Uniswap simultaneously, the price shown when you place your order may be different from the actual price when the order is executed. This phenomenon is called “Slippage” and you are able to cap how much slippage you are willing to tolerate before cancelling your order.
The reason for slippage is that every trade on Uniswap is actually an Ethereum transaction and it can take some time to broadcast the transaction and get it confirmed by the Ethereum network. By the time the transaction is confirmed, the price may have already changed.
Attention Uniswap Users!
Due to its decentralized and non-regulated nature, Uniswap supports many types of ERC-20 tokens. In fact, practically anyone can create their own token and list it on Uniswap for free, filling Uniswap with a wide variety of tokens but unfortunately a fair number of scam coins as well.
Just because a coin is listed on Uniswap doesn’t mean it’s legit or has any intrinsic value. As opposed to a traditional exchange that does extensive due diligence and research on every coin it adds to its platform , Uniswap doesn’t. So – it’s up to you to Do Your Own Research as they say and decide if you want to invest in a certain coin.
5. The UNI Token
In September of 2020 Uniswap introduced the UNI token through an airdrop. Each person who previously used Uniswap received 400 UNI tokens for free.
UNI was designed to serve as a governance token, allowing whoever holds it to influence and vote on development decisions. The more tokens you hold, the more voting power you have. The idea is for the Uniswap team to gradually fade out their involvement in Uniswap and leave the management of the project to the token holders.
Interestingly, while it was never designed to serve as a currency, UNI has risen in value since it was introduced, often occupying a spot among the top of the cryptocurrency list. It seems that the reason for that is that the price of UNI represents how valuable people believe that Uniswap will be in the future, and therefore are willing to pay to be a part of its governing body.
In the cryptocurrency space it’s not uncommon for coins that never had any intention of being used as a financial asset to become very valuable. In the end it’s up to you to decide if being a part of the Uniswap governing body is worth the price of the UNI token.
6. Conclusion
Uniswap is a DEX that allows users to trade any ERC-20 token without any intermediary; With DEXs, you don’t need to deposit funds to a centralized exchange that has complete control of your funds.
Instead of a privately controlled order book, Uniswap’s exchange operations are conducted over smart contracts that define and comprise all trading conditions, such as liquidity and the traded assets’ prices.
To gradually hand-over governance over Uniswap to the public, its developers created UNI. UNI is an ERC-20 token used within Uniswap’s voting mechanism, where the more UNI you have, the higher your voting power is and the more influence you have over Uniswap’s developmental future.
While UNI was never intended to be used as a currency, it’s price has climbed up to the top of the cryptocurrency list, mainly due to the high popularity of Uniswap.
That’s it! If you have any questions or personal experience with Uniswap you wish to share, please share it in the comments section below.
