Defi

What Is Uniswap? A Complete Beginner’s Guide.

Uniswap is the largest decentralized exchange (DEX). It has close to 90% market share and facilitates transactions with a total volume worth over $1billion daily. As at the time of writing this post, it has close to $5 billion locked in its liquidity pools.

Before Uniswap, crypto traders could only use centralized exchanges like Coinbase, Kraken and Binance. These have many weaknesses, at the top of the list being that they’ve turned into major single points of failures in the crypto and blockchain space.

Indeed, they are now honeypots that hackers targets relentlessly. Since 2013, no year has gone by without an exchange being hacked and a significant amount of crypto stolen. Sometimes several exchanges are hacked in a year.

bitcoin-thieves

Meanwhile, for any forces interested in controlling what happens in the crypto market, exchanges are turning into great leverage points

This is a major concern, especially given that the invention of Bitcoin was fueled by the desire to have a global financial system that is not controlled by a few overlords. 

It makes little sense therefore to take the control of the financial system from the central banking system and give it to exchanges, whose structure is not any different from that of banks.  

The exchanges could easily turn into the new power brokers in the financial system. 

Regulators around the world seem to have identified the exchanges as the vehicles for dismantling the privacy wall that crypto has promised its users.  

Being registered and heavily regulated businesses, centralized exchanges are easily compelled by the threat of being denied operating licenses to do the bidding of those wielding power of government.

In the beginning (until around 2017), you could buy and sell bitcoin on exchanges like Coinbase, Kraken and Huobi without having to share your identity with them.

Today all of them, including the peer-to-peer Localbitcoin and Paxful, demand that you must submit a government issued identity document before they can let you trade. In addition, they want you to verify your address and give them your facial image. 

While you can hold your crypto assets anonymously, you have to disclose your identity when buying and when selling. That makes it easier for those watching the blockchains to attach transactions to real world identities. Meaning, it has become easier for crypto transactions to be tracked. 

Even more, centralized exchanges are collecting and keeping a lot of data on databases whose security cannot be guaranteed. It should also not be lost to us that the data is stored in centralized databases that can be hacked and stolen. 

With this information in third party hands, anything is possible in regard to assets and even personal physical security. 

Also, government agencies are now demanding that the exchanges share the data with them. 

For example, though not legally compelled, Coinbase now sends form 1099-k and 1099-MISC to its users. These are legal documents requiring the buyers and sellers on the exchange to declare their gains to the Internal Revenue Service (IRS). When one files their returns, the information the exchange shared with the tax collector would disclose unreported activity.

There have been reports that these forms have led to false alarms—the IRS believing Coinbase users are under-reporting while in actual sense they are not.

For these reasons, and others, it was important that decentralized exchanges (DEXs) were developed. Uniswap is among the first to be launched and has continued to lead the way in this category.

Uniswap-Liquidity

So, how does Uniswap work?

The idea of a decentralized exchange running on the Ethereum blockchain was first put forward by Vitalik Buterin in a post he published on the Ethereum subReddit in 2016. A year later Hayden Adams, a blockchain enthusiast and developer, started working on it. 

Hayden Adams launched it in November 2018 as a decentralized application (DApp) in the Ethereum blockchain. 

anatomy

All the operations and processes of Uniswap are managed and executed by a smart contract. That means every step of a transaction is automated on the blockchain. With that being the case, Uniswap has no management team or a staff that executes any tasks. It is indeed a decentralized anonymous organization (DAO).

So there is no one a government agency or a regulator can target or pressure to have the application abide by any regulatory requirement. Likewise, the authorities cannot force it to be switched off. The only way to kill it is by shutting down the entire Ethereum network, which itself is near impossible.

Therefore, it is unlikely that Uniswap users, for example, are going to be asked to share government issued identity documents to continue using the platform.

The listing of new coins 

For a new coin or asset to be listed on a centralized exchange, the administration has to assess it and make the decision to list. Many times they decline to list an asset for one reason or another.  

On Uniswap, there is no admin to grant permission to the listing of a new coin. Those behind the new coin can do it themselves, and this includes creating the necessary smart contract address on Etherscan, Ethereum’s block explorer. It is through this address that a coin interfaces with the primary Uniswap smart contract. 

Then on the Uniswap platform, they create pairs and add liquidity for them so that if someone wants to swap the new coin for another, there is a pool to support the transaction. Indeed, many projects find ways to incentivize investors to become liquidity providers for their tokens. 

 On Uniswap, the door is open to anyone to list their coin, and the success or failure of the coin on the platform depends on the strategy by the creators, and in particular the ability to attract investors as well as liquidity providers. 

This is a good and bad thing at the same time. It is a good thing because products don’t arrive at the marketplaces because of the whims or interests of a gatekeeper. All projects have an equal shot at success. 

We will see how not having an admin to assess a token before it is listed  is a bad thing when we focus on the disadvantages of Uniswap. First, let’s look at liquidity pools. 

DEX and liquidity pools

When you trade on a centralized exchange, often you are either trading with the exchange itself or the exchange is linking you with offers by other users on the platform. In other words, the exchange maintains an order book. 

Uniswap and most of the early decentralized exchanges could not function using order books. The developers had to come up with an innovative way to guarantee that if you needed to buy a particular asset, you can get an offer, and vice versa.

Hayden Adams to work with the concept of liquidity pools. These are basically wallets that are controlled and managed by a smart contract. Each pairing will have a distinct liquidity pool to serve those who swap the assets. For example, Ether/DAI pairing has a liquidity pool, so does WBTC/USDC.

That means if you want to convert your ETH into DAI, you send your ETH into the ETH?DAI liquidity pool and an equal amount of DAI is released to your connected wallet.

Now, who makes the funds available in the liquidity pools so that if you want to swap it works?

Anyone with extra funds to spare is welcome to contribute to the liquidity pools. You have to pick the specific liquidity pool of a pairing you like and fund it on a 50-50 basis. For example, if you want to fund the Eth/DAI pool, then you are supposed to deposit equal amounts of Eth and DAI to the pool.

To do this:

  • Click on the ‘Pool’ tab on app.uniswap.org
  • Select ‘Add liquidity’
  • Select your pairs
  • Connect your wallet (if you haven’t already) and transfer the assets

In return, you become entitled to a share of the fees that users pay to utilize the liquidity pool. The person who contributes their coins to a liquidity pool is known as a liquidity provider or miner

After adding your assets in a pool, you receive special tokens (pool tokens), which automatically earn fees proportional to your share of the pool. You can redeem the pool tokens any time you want.

Meanwhile, when someone creates a new coin and they want it to be traded on the Uniswap exchange, what they do is to create a contract for it on the platform and then request some people to become its liquidity miners. 

It is important to point out that there is a new category of decentralized exchanges that are implementing order books on the blockchain. An example of such a project is Project Serum. How this works is beyond the scope of this guide.

How does the Uniswap smart contract manage the asset prices?

The Uniswap protocol relies on the supply and demand to make price calls. It is connected to outside oracles (machines, networks and service providers that collect and relay market data in real-time) that supply it with market price data. How oracles work with the Uniswap protocol is beyond the scope of this guide. 

The governance structure

All decisions on the Uniswap platforms are guided by a smart contract. The coins that get listed come with their own smart contracts that have to talk to the main smart contract. 

With that stated, the users of the platform can make critical policy decisions and changes to the primary smart contract (core protocol) through a voting system. There is a platform on which community members make proposals on the changes they want to see in the core protocol. These proposals are discussed and then voted upon.

In order to take part in the voting process, you need to acquire UNI tokens, which are Uniswap’s native tokens. You can buy them on the exchange just like any other ERC20 tokens. 

How to use Uniswap as an exchange

Uniswap has perhaps the simplest user interface of any exchange out there. You can access it on app.uniswap.org.

You don’t need to sign up. All you need to do is to connect your wallet. The wallets you can connect include Metamask, Coinbase or Portis. You have a longer list of wallets to choose from when you connect using the Walletconnect interface. See here below a video how you can connect for example your MetaMask with Uniswap.

That means before you use Uniswap, you need to make sure you have one of the compatible wallets. With that, connecting is easy. All you need to do for most of the wallet is either have it open on your browser (in the case of Metamask) or scan a QR code. 

With the wallet open, you can just swap the amount you want in it with another listed coin. The amount will leave your account into the liquidity pool and the coin you need will be transferred from the liquidity pool into your wallet.

The cost of using Uniswap.

To use Uniswap is not free of charge. There are three items in the cost that you will incur while using the exchange.

Liquidity pool fees

The exchange protocol charges users a percentage for the service. However, this amount does not go to any corporate entity to take care of costs and contribute to profits in books of accounts. The fee accumulated is shared among liquidity providers. The fee is charged at a flat rate of 0.30%.

The gas fee

The other cost you have to incur when using the Uniswap exchange is the gas. Remember, all transactions on the exchange have to be confirmed on the Ethereum blockchain. The Ethereum blockchain requires gas to be paid for each transaction.

The amount you pay depends on the volume of transactions by other traders waiting to be confirmed and how fast you need yours to be done. The faster you need your transaction to be confirmed, the higher gas fee you should be willing to pay.

Always confirm the amount of gas the exchange quotes for you and adjust accordingly. If you are not in a hurry, reduce it, and if you need a quick confirmation, consider increasing it. 

Slippage

Slippage is a cost that might come into play without you noticing it. This is the difference between what you expect when you initiate a trade and what you actually get when the transaction is completed. 

It often happens that between the time you initiated a transaction and when it is executed, the price of the assets involved has changed. However, the exchange allows you to set the amount of slippage that is acceptable to you before you initiate the trade. You should utilize this feature. 

How you can make money on Uniswap

There are several ways through which you are likely to make money on the Uniswap exchange. The following are some of them:   

Conventional trading

You can buy and sell tokens to make a profit depending on market prices. That means buying low and selling high or shorting the market when you can. Indeed, Just like you look for opportunities in centralized exchanges such as arbitrage, you can do the same on the Uniswap exchange.

Yield farming

This is the most popular way of making money using the Uniswap exchange. This involves borrowing and lending different assets as part of a strategy to increase your worth.

The simpler version of yield farming is lending and expecting a return in interest. The most complex version includes borrowing assets, swapping them on Uniswap and lending out or trading the acquired assets to generate revenue that can pay the initial loan and make a profit.

This is a highly risky endeavour and only engage in it if you have the necessary skills, in particular, measuring risks and anticipating market movements.. 

Liquidity mining 

As mentioned earlier, the tokens that users buy are provided by others in pools (wallets managed by smart contracts). You can easily join the liquidity pool and contribute to the coins needed.

By doing this, you stand to share in the fees that users pay. For a better chance of succeeding, select a mining pool with increasing activity, but with not so many miners taking part. Often a pair with a rising coin can provide a better amount of revenue.

Does Uniswap have a future?

Uniswap is increasing in importance with more coins being launched. There is also a growing interest as more people learn about crypto. Meanwhile, as the pressure on centralized exchanges to collect data about their users grows, many are choosing to use decentralized exchanges like Uniswap. 

With that being the case, Uniswap faces competition from other DEXs, and in particular those that are launching on blockchain that have increased transaction capacity and can transact coins from different blockchains. 

An example of such a competitor is Serum (the on-chain order book DEX mentioned above), which runs on a protocol that is cheaper and faster. 

Advantages of Uniswap

So there are several advantages that Uniswap affords its users. The following are some of them:

  1. Improved privacy to transactions. You don’t have to share any personally identifying information to use the platform.
  2. Better security because all transactions are non-custodial. You don’t maintain a wallet or an account on the trading platform. To start using Uniswap, you must link your wallet (Metamask is used most for this purpose). Every coin you sell comes directly from your wallet directly to the liquidity pool and vice versa.
  3. Also, the chance of massive hacks is none existent because there does not exist one huge hot (or even cold) wallet that can be targeted and compromised. In other words, you never hear of Uniswap losing hundreds of millions worth of coins to some hackers. 

Disadvantages of Uniswap

Uniswap has drawbacks and shortcomings. The following are some of them:

  1. Only tokens created on the Ethereum blockchain are tradable on the Uniswap exchange. In order to trade something like Bitcoin, it was necessary to create its representation on the Ethereum, a process known as wrapping (thus we have Wrapped Bitcoin (WBTC) on Uniswap and not Bitcoin).
  2. Because there is no one to assess and audit tokens before they are listed on the exchange and token owners have all the control of the listing process, the exchange is full of copies and fakes that are intended to hoodwink investors. For example, it is possible to swap your coins with what turns out to be a fake of what you intended. Therefore, as an investor, it is important to do due diligence before you buy or swap a coin. One way to know if you are dealing with a genuine coin is to search it using its smart contract address that is found on Etherscan. And because con artist can easily add an address on Etherscan, you should first identify the address for the genuine coin on crypto market data aggregators like Coingecko.com.
  3. The risk of compromised smart contract code. To list a coin on the exchange, dev teams have to create their own smart contract that talks to the Uniswap protocol and executes transactions. It is however possible for the team to create a backdoor through which they can compromise their own smart contract and steal from you. It is for this reason that you should only buy and sell tokens whose credibility has been established in the public domain.
  4. Related to backdoor code compromise, is what has come to be known as the flash loan attacks. This is where a hacker sets up or takes over an oracle and feeds wrong price data to the exchange and thus creates opportunities to generate profit for themselves. Hugely this has been corrected through preference for reputable oracles.

Conclusion

Even with all these weaknesses, the idea of a decentralized exchange is a powerful one, and Uniswap has proven it can work. Moreover, millions of users from around the world have found it useful and have accessed opportunities not found elsewhere. 

If you are concerned about your privacy while trading assets online, then Uniswap is an exchange to seriously consider. However, it is important you understand how it works and how to protect yourself from its drawbacks.  

Disclaimer:

This is not financial advice. You are responsible for whatever outcome you get from using the information shared.

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