The first cryptocurrency exchanges emerged in 2010, a year after Bitcoin was founded. The so-called Centralized Exchanges (CEX) were the first crypto-active trading platforms, with the extinct Mt. Gox being the largest and most famous of this generation.
Since then, these centralized trading markets have evolved significantly, improving aspects such as ease of use, user interfaces, and integration with various fiat tokens, making it easier for the general public to access the crypto market. The most important ones currently include the Brazilian Mercado Bitcoin as well as the international ones Binance, Coinbase and Kraken.
Despite these advances, the model of these exchanges has a critical point: the custody of customer assets is the responsibility of the institution. This trust factor, coupled with exchanges’ vulnerability to cyberattacks and fraud, has led to infamous incidents such as the infamous Mt. Gox hack in 2014, which resulted in the disappearance of 650,000 customer BTCs – more than 5% of all existing ones BTC’s the time.
Another notable event was the collapse of FTX in November 2022. The broker invested its customers’ crypto assets into its own investments, causing its customers a loss of $8.9 billion.
With the launch of the Ethereum ecosystem, the first network to support the creation of smart contracts, smart contracts – digital agreements that are automatically executed according to pre-determined programming – new financial products and services began to emerge.
These solutions include DEx, a decentralized exchange that counterpoints CEx. Currently, Uniswap is the largest of them, representing more than 54% of this market’s trading volume over the past three months. To give an idea of Uniswap’s size, its trading volume is currently about 90% of that of Coinbase, the largest crypto broker in the US.
In order for transactions to take place on Uniswap, it is necessary to understand two fundamental roles that its participants fulfill: that of the liquidity provider and that of the trader. Liquidity providers are those who make token pairs available in liquidity pools for other agents to buy and sell tokens. Traders are those who carry out transactions against liquidity pools, supplying them with their tokens and receiving the requested tokens in return.
Furthermore, the market price is defined by an algorithm and depends on the amount of tokens in the liquidity pool, as we will see below. This is a fundamental difference between Uniswap’s trading method and that of the order books widely used on the world’s largest exchanges and CEx.
Let’s look at a simplified example of how the first version of Uniswap works. Suppose there is a multi-participant ETH/USDT liquidity pool containing 100 ETH and 200,000 USDT. Imagine a trader wants to exchange 1 ETH for USDT against this liquidity pool. The market price is defined by the USDT amount divided by the ETH amount, i.e. 1 ETH = 2,000 USDT. In this way, the trader delivers 1 ETH to the liquidity pool and receives 2,000 USDT minus the liquidity reward and transaction fees.
In practice, it is possible to quantify the liquidity premium because the price is defined by an algorithm. According to the algorithm, when delivering 1 ETH to the liquidity pool, the trader must be penalized 1 – 100/101, which is approximately 1%. That is, the percentage liquidity premium is 1 minus the initial amount of ETH from the liquidity pool divided by the new amount of ETH after the transaction.
In this way, the trader actually receives 1,980 USDT for his sale. The difference of 20 USDT to the price of 2,000 USDT remains in the liquidity pool and is distributed among the liquidity providers. This difference is called slippage. In addition, a transaction fee is charged for liquidity providers. In this way, liquidity providers are compensated for offering their tokens for trading.
Liquidity pools allow any token holder, large or small, with or without market experience, to make their assets available for trading in order to receive a portion of the fees and liquidity rewards that traders leave behind on transactions.
In a way, within the crypto active environment, Uniswap democratized the activities of market makers in traditional markets, which were limited to large operators in the financial market. Here’s a warning: If the liquidity provider seeks returns by providing liquidity, it takes on other types of risks, such as temporary loss. In our example, as ETH appreciates relative to USDT, the liquidity provider will give up some of the appreciation of ETH.
The exchange rules shown above are set in smart contracts that anyone on the Ethereum network can access. Nobody can remove these contracts from the network. The contracts are open source so anyone can examine them to see if they do what they are supposed to.
Another feature of Uniswap is that it does not hold the assets of any market actor, not even liquidity providers, who also fulfill their role through smart contracts, thus avoiding the risks that led to the crash of Mt. Gox and FTX. Due to these characteristics, Uniswap is recognized as a decentralized cryptocurrency exchange or broker, a DEx.
Uniswap has evolved over time through its successive versions. In the first version, launched in November 2018, all trading pairs were required to include ETH, the native cryptocurrency of the Ethereum network. It was a promising but limited beginning. People wanted more flexibility, they wanted to be able to exchange any cryptocurrency directly with another without always having to go through ETH.
Given this need, the second version of Uniswap was launched in May 2020. Now users can create liquidity pools with any crypto-active pairs, allowing greater flexibility in creating new pools without being limited to always creating a pair with ETH.
The launch of V2 came at an opportune time, at the beginning of the development and launch of the main decentralized finance protocols – AAVE, COMP, SNX, YFI – which subsequently led to one of the highest valuations in the industry, especially at the end of 2020. 2021, what became known as DeFi Summer.
Originally, Uniswap only existed on the Ethereum network, but that changed in September 2021 when it also began operating on the Arbitrum network, paving the way for multichain development. Later, operations also began on the Optimism, Polygon, Celo, BNB, Avalanche and Base networks in that order.
However, despite this new freedom, the efficiency of capital allocation has still not been optimized. In practice, this meant that the liquidity offered in a liquidity pool could be pooled, in the sense that there were no trades for different price ranges in which liquidity was offered.
At this point, the third version of Uniswap introduced a new functionality: liquidity providers could define specific price ranges to provide liquidity, allowing them to focus their resources on the price at which the greatest market activity occurred, thus increasing capital efficiency.
Despite the improvements in technologies developed through the protocol, innovation is not yet over. In 2023, Uniswap Labs, the company behind funding the protocol, began developing its fourth version with the community of users and developers.
The aim of this version is to offer participants new functions such as: Such as the ability to execute limit orders, the creation of custom functions, as well as reduced costs for listing a new pair and executing trades in the protocol. The update is planned for next year and will be a great added value for Uniswap itself and for the still young decentralized finance sector.
About the author
Bernardo Bonjean is an entrepreneur with extensive experience in the financial industry and fintech, having started his career in portfolio management at Banco Pactual in 2002. In 2008 he joined the XP Investimentos team as Head of Sales and Trading and during this time he took part in: the OPM course at Harvard and left the company to found Avante. During the Covid-19 pandemic, Bernardo revived his passion for crypto with Metrix.
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