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At the beginning of 2018, decentralized finance (DeFi) was far more vision than industry, manifesting itself in applications and code. Only a small handful of use cases have been fully tested. However, in November this year, DeFi took a significant leap when software developer Hayden Adams announced the launch of a new application called Uniswap. Uniswap is a decentralized peer-to-peer exchange (DEX) and facilitates trading of ERC-20 tokens on major blockchains such as Ethereum. For this purpose, Uniswap uses an Automated Market Maker (AMM), which replaces the role of the order book on a traditional exchange.
Distinguished by its elegant design, simple interface, composability with decentralized applications (Dapps), and philosophical focus on cryptoassets, Uniswap has been widely adopted within DeFi. Today, Uniswap regularly processes billions of dollars in daily trading volume and is the fifth largest DeFi application in terms of Total Value Locked (TVL). As the undisputed leader in decentralized asset exchanges, Uniswap stands to benefit significantly from the continued growth of the DeFi ecosystem.
The central theses
- Uniswap is DeFi’s largest and most liquid decentralized exchange (DEX). Uniswap is best known for its automated market maker (AMM), which ensures that liquidity is always available to trade, regardless of order size or the presence of a counterparty.
- Uniswap’s codebase meets the standards of major blockchain ecosystems such as Ethereum. This feature gives Uniswap a high level of composability across DeFi applications and positions it as a cornerstone of the DeFi ecosystem.
- Uniswap’s smart contracts introduce features not typical of a traditional exchange, such as: B. direct allocation of trading revenues to individual liquidity providers, democratization of power to create new markets, and near-instantaneous trade settlement. Uniswap is governed by holders of the UNI token, who have the power to vote on governance proposals that include revenue distribution agreements, fee structures, product offerings, and protocol strategy.
Uniswap uses smart contracts and mathematics to reinvent financial exchanges
Most traditional asset exchange platforms use an order book to facilitate trading. This requires the exchange to maintain a list of all buy and sell orders for an asset, including order amounts and prices. Additionally, every trade requires a counterparty: a party willing to buy each sell order and a party willing to sell each buy order. Also crucial to the traditional stock market is the market maker, an intermediary who adds liquidity and depth to a market for an asset by continually quoting both sides of the market.
Uniswap is designed to eliminate these processes and facilitate the exchange of assets without the involvement of central parties or intermediaries. To achieve this, Uniswap uses liquidity pools and a constant product feature to create an automated market maker (AMM) system. This unique infrastructure ensures that liquidity is always available for trading, regardless of the presence of a counterparty. This infrastructure also provides the secondary benefit of allowing price discovery to occur natively within the DeFi ecosystem.
Liquidity pools are smart contracts that provide a frictionless trading venue
Liquidity pools serve as individual marketplaces for exchanging assets on a DEX. Uniswap’s pools use two different tokens, a trading pair, in quantities proportional to their relative market prices. The tokens are crowdsourced from DeFi participants, so-called liquidity providers (LPs), and form the pool of money against which liquidity seekers or traders trade. The smart contract logic that governs these pools allows a liquidity demander to exchange one of the pool’s tokens for another based on an algorithmically derived exchange rate.
With a large order book, institutional market makers have an incentive to act as counterparty to trades by benefiting from the bid-ask spread. Likewise, LPs on Uniswap demand compensation in exchange for locking their assets in a smart contract. To incentivize liquidity provision as a service, LPs receive a prorated share of a pool’s trading fees. In Uniswap v3, the latest version, LPs can deploy funds at four fee tiers: 0.01%, 0.05%, 0.3% and 1%.1
Liquidity pool-based exchanges take a unique approach to setting market prices
In an order book, the market price is determined by the point where the highest bid price meets the lowest ask price. Since Uniswap does not use an order book, no bid or ask prices are available for reference. Instead, Uniswap uses a constant product function to determine asset prices. This approach can be summarized by the equation x*y=k, where x is the amount of token A in a liquidity pool, y is the amount of token B in a liquidity pool, and k is a constant number. As the ratio of Token A to Token B fluctuates with trading, the exchange rate between the two assets changes in response.
Imagine a liquidity pool of 1,000 ETH (x) and 1,000,000 USDC (a USD-pegged stablecoin) (y). Initially, the pool implies a price of 1 ETH = $1,000, and the constant product (k) of the pool is 1,000,000,000 (1,000*1,000,000 = 1,000,000,000).
Now consider the impact if a trader uses this pool to exchange some amount of USDC for 5 ETH. As shown in the table below, withdrawing 5 ETH (“Purchased ETH” = 5) would leave 995 ETH in the pool (“New ETH Liquidity” = 995 = x). To maintain a constant product of 1,000,000,000, the user would need to deposit enough USDC to bring the constant product k back to 1,000,000,000. In this case, a withdrawal of 5 ETH would require a deposit of 5,025.13 USDC or approximately $5,025.13, resulting in a total amount of 1,005,025.13 USDC (“New USDC Liquidity” = 1,005,025.13 = y ) in the pool. This amount is confirmed by the equation: 995*1,005,025.13 = 1,000,000,000. Based on the new ETH/USDC ratio in the pool, the new implied price of ETH after trading would be 1,005.03 USDC (“Cost per ETH” = 1,005.03 USD).
The constant product function ensures that the USDC-denominated ETH price asymptotically increases as the amount of ETH withdrawn from the pool increases. In other words, larger orders have a greater impact on the market price of the assets that make up a liquidity pool, but have the advantage that the system always has liquidity to trade. In reality, large liquidity pools are much larger than shown in this figure, meaning that trades of a given size have a far smaller impact on market prices. As of January 23, 2023, Uniswap v3’s ETH/USDC pool consists of approximately 108,630 ETH across all 4 fee tiers, which is worth approximately $177.1 million at the time of writing.2
Arbitrage also plays a crucial role in maintaining the accuracy of asset prices on Uniswap. Since asset prices are influenced by the relative supply of tokens in liquidity pools, small imbalances can cause prices on Uniswap to mismatch those on centralized exchanges. In practice, arbitrageurs who align Uniswap pools back to centralized exchanges are quick to exploit these small price differences.
Uniswap is uniquely positioned to serve the DeFi ecosystem
Uniswap’s approach to asset exchange improves the liquidity profiles of crypto assets. As long as a token pair has an active liquidity pool, users can execute a trade at any time. Uniswap’s AMM also allows users to create new markets for any token on the ERC-20 standard without incurring listing fees. An immediate benefit of the AMM is the ability to create active markets for exotic and illiquid tokens, including tokens from emerging and early-stage protocols.
Since LPs only have incentives to contribute to liquidity pools that offer the prospect of trading revenue, rational economic behavior determines which markets capital is allocated to. The result is high liquidity in the most active trading pools and more efficient capital allocation to promising but more esoteric areas of the market. A May 2022 study found that Uniswap v3’s AMM had about twice the market depth – a commonly used measure of liquidity – for spot ETH/stablecoin markets than the largest centralized exchange platforms.3
As a blockchain-native application, Uniswap benefits from the operational efficiencies associated with smart contracts and blockchain technology. Because Uniswap conducts trades over blockchains like Ethereum, users benefit from near-instant settlement while receiving robust security guarantees. Users can also expect to pay lower fees on the platform, partly due to the lower cost of disintermediation.
Additionally, the Uniswap protocol is coded according to Ethereum standards, meaning Uniswap benefits from a high level of compatibility with applications across the DeFi ecosystem. Uniswap can be easily integrated into decentralized applications of all kinds, serving as a backend trading infrastructure, a permissionless market data feed, a source of organic yield in DeFi, and more. Uniswap’s unique features position the platform as a crucial monetary lego for the DeFi ecosystem, offering a value proposition that is unlikely to be challenged by its centralized counterparts.
UNI token gives owners influence over the strategy of the protocol
Uniswap’s native asset, UNI, is a governance token that represents collective ownership of the protocol. Holders of the UNI token have the right to participate in Uniswap’s on-chain governance process by voting on governance proposals. By expanding voting powers on issues such as fee structures and revenue sharing arrangements, UNI owners are the stewards of the protocol and its strategy. Currently, UNI owners do not receive any trading fees or revenue from the platform, although numerous proposals to allocate a portion of these fees to owners are being explored.
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