Trading Uniswap at SMART VALOR
In a few short years, Uniswap grew from an obscure software project to one of the most valuable tokens in cryptocurrency, with a total value exceeding $22 billion USD. So what is behind the meteoric rise of Uniswap, and will it be able to maintain this growth rate?
To answer these questions requires understanding the context in which Uniswap emerged, and the problem it solved.
The Need for Decentralized Exchanges
Cryptocurrency first emerged in the backdrop of the global financial crisis of 2007-08. The first cryptocurrency, Bitcoin, was intended as an alternative to economic policies that were seen by some critics as irresponsible and immoral.
This movement was at first characterized by a radical ethic of decentralization. The idea was to build a financial network with no centralized authority immune to abuses of power. This is when the first decentralized exchanges, now popularly known as DEXs, were created.
These decentralized exchanges are where people can go to trade cryptocurrencies directly, without the need for any intermediary. Instead of the exchange being used to facilitate trades the decentralized exchange uses smart contracts, which is like a software application that sits on the blockchain and executes whatever instructions have been programmed into it.
Cryptocurrency enthusiasts and entrepreneurs raced to develop exchanges that would be as decentralized as the assets that traded on them. However, these efforts faced major challenges, most notably a lack of liquidity, which made trading difficult.
Uniswap was the first decentralized exchange (DEX) to develop a solution to this problem.
A Brief Introduction to Uniswap
Uniswap launched in 2018 on the Ethereum network and was aimed at creating a decentralized platform where users could trade all of the thousands of ERC-20 tokens available. All that’s needed to use Uniswap is a wallet capable of holding these ERC-20 tokens like MetaMask. With that wallet a user can connect to Uniswap and trade nearly any of the ERC-20 tokens. Unlike many other decentralized exchanges, Uniswap uses liquidity pools rather than an order book.
As of September 2021 Uniswap remains the largest DEX in operation, with over $6 billion in Total Value Locked (TVL), which is a measure of the value of all the cryptocurrencies currently being held in Uniswap’s liquidity pools.
In terms of trading volumes, Uniswap is also ahead of its competitors. In September 2021 the trading volumes ranged roughly from $1 billion to $2 billion daily. The most-traded tokens on the platform are Ethereum, USDC, USDT, and wrapped Bitcoin.
How Uniswap Works
Anyone is able to create a market (liquidity pool) for a trading pair on Uniswap by providing an equal value of ETH and some other ERC-20 token. At Uniswap only one market per ERC-20 token is allowed, and the creator of the market sets the exchange rate which changes based on trades and the instructions encoded in the smart contract. Each pair is represented by a unique and freely transferable ERC-20 token.
The benefit to the market makers for providing liquidity is a share of the fees collected on Uniswap trades. The exchange collects a 0.3% fee on each trade, and these fees are then split amongst the liquidity providers proportionally.
Uniswap has a few key components that we should take a closer look at:
Automated Market Makers (AMMs)
Uniswap made history with the development of the world’s first automated market makers (AMMs). In traditional markets, prices are set by order books which match buyers and sellers by listing current offers.
AMMs, on the other hand, adjust the price of an asset automatically according to actual buying and selling prices. Each AMM is created by providing an equal amount of Ethereum and any other Ethereum-based token to a smart contract. This way, each AMM represents a different trading pair.
As traders buy or sell one of the assets in the pair, the balance of the assets in the smart contract shifts, and the price shifts with it according to a predetermined algorithm.
Since an AMM is a smart contract on the Ethereum network, it can be completely autonomous after launch, removing the risk of abuse or negligence by a trusted party. Each Uniswap user remains completely in control of their funds at all times.
An AMM can start out with a small amount of funds, but as it grows, it will need more liquidity. Liquidity providers can earn fees and rewards by providing funds to an AMM. When liquidity providers add funds to a pool, they receive liquidity tokens which can be redeemed for their percentage of the pool, plus their percentage share of earnings.
The Uniswap Factory
Another smart contract called the Uniswap factory helps users to easily create AMMs, meaning anyone can list a token on Uniswap. The only cost is the network fees for the contract and the tokens required to provide the initial funding.
Uniswap’s Governance Token
Uniswap was created as an open-source project, which fits well with the decentralization of the exchange. However this also made it easy for others to copy the exchange and set up competing exchanges. That happened quickly and today there are a number of competing exchanges such as Sushiswap, Sakeswap and Defiswap.
To combat the rising number of competitors, Uniswap’s native token (UNI) was released in September of 2020, about two years after the launch of the platform. This move was motivated partly by competitors like Sushiswap which were billing themselves as more democratic and inclusive than Uniswap.
Like most tokens issued as rewards by decentralized exchanges, UNI is a governance token. This means that owning UNI lets you vote on decisions about the platform’s development.
Investors and traders who earn money through the platform have a special interest in ensuring Uniswap’s continued success. This makes UNI a desirable commodity for those wishing to have a say in the direction Uniswap takes.
The Future of Uniswap
DEXs will likely continue to gain popularity for the foreseeable future. One reason is that anyone can use them without needing to reveal their identity. This makes them attractive to people concerned about privacy, or those who may not be able to sign up for centralized exchanges in their country.
However, regulators have their eyes on the DEX, and will almost certainly come out with regulations in the future to help protect consumers. As a result, Uniswap is reportedly already working on a KYC solution to keep regulators appeased.
The future of DEXs in general is certainly not assured. The question is, assuming DEXs do survive, how big a share of that future belongs to Uniswap.
Uniswap provided a novel solution to an important problem facing cryptocurrency, and secured its position as the leading DEX. However, since Uniswap is open source, it’s easy for competitors to copy the code and start their own DEXs. In its favor, Uniswap is still the largest DEX and has largely avoided the hacks that have affected many other areas in DeFi.
Also important to consider is the fact that Uniswap is very tightly linked to Ethereum. Uniswap’s long-term success is in some ways dependent on Ethereum’s success. Today, the Ethereum ecosystem remains by far the strongest smart contract platform - but competitors are trying to catch up. If Ethereum succeeds in deploying functional scaling solutions, the future is likely to be bright for Uniswap as well.
SMART VALOR’s DeFi platform supports the Uniswap UNI token, allowing investors to easily gain exposure to the rapid growth of this part of the DeFi ecosystem.