What is Uniswap?

Uniswap is a decentralised exchange (DEX), and one of the core pillars of the DeFi ecosystem. DEXs seek to give users an alternative to their centralised peers, allowing users to trade without trusting a centralised party, which leads to non-transparent risks around hacking, management of funds and arbitrary fees. Ultimately, decentralised finance (DeFi) aims for non-custodial products, such as Uniswap, to dethrone these centralised ‘middlemen’.

The Uniswap Protocol is essentially a group of smart contracts that when combined, create an automated market maker (AMM) that facilitates decentralised market making and swapping of tokens. Market making in this scenario is achieved through providing liquidity to pools to earn fees, where the market maker is the liquidity provider (LP). These liquidity pools are a pool of funds from LPs locked in a smart contract. It is from these pools that users can trade by swapping tokens to and from the pool.

The main features of the protocol are:

  • Permissionless creation of pools for any ERC20 tokens
  • Swap tokens between any created pool
  • Provide liquidity to earn fees
  • User-friendly UI
Uniswap Pool Illustration
How a Uniswap Pool Works.

Uniswap V2 vs Uniswap V3

Uniswap V2 was the current version of Uniswap before the launch of Uniswap V3 in May 2021. The major changes between the two versions focus on improving user experience, fees and overall performance.

In Uniswap V2 pools, liquidity is uniformly spread across the entire price curve from 0 → ∞. This price curve is defined by x * y = k, where x is the number of token A, y is the number of token B, and k is a constant. This is known as the ‘constant product’ formula. In essence, this means that trades change the balance of reserves (x, y) resulting in a new price.

In Uniswap V3 pools, LPs can allocate their liquidity to custom price ranges, ensuring higher efficiency of liquidity for the pool and a higher reward for LPs. Previously in V2, the majority of liquidity was never used, especially in stable pools where approximately 0.5% of the total capital was available for trading. ‘Concentrated liquidity’ acts as a mechanism that lets the market decide the distribution of liquidity. This is because rational LPs will be incentivised to concentrate their liquidity whilst also ensuring that their capital remains active.

Uniswap V2 Trading Mechanism.

What Networks is Uniswap Available On?

Uniswap is fairly selective in the chains it supports, having a very Ethereum ecosystem-focused scope. It is currently available on:

  • Ethereum (Layer 1 mainnet)
  • Polygon (Ethereum sidechain)
  • Arbitrum (Ethereum optimistic rollup)
  • Optimism (Ethereum optimistic rollup)
  • Celo (Mobile-first Ethereum Virtual Machine [EVM])

What Assets are Available on Uniswap?

As the Uniswap Protocol is permissionless, any ERC20 token can be combined with another to create a pool using the Factory smart contract. Once liquidity is added to the pool, it can be freely traded by anyone.

How can I Earn Yield with Uniswap?

There are a few ways that users can earn yield and interest when interactin with the Uniswap protocol. The most popular method is by providing liquidity, or being an "LP". In future, users also expect that the Uniswap protocol will activate their fee switch, which will enable stakers to earn a share of revenue from protocol fees. Continue reading for a deeper breakdown.

Providing Liquidity

Currently, the only way to earn yield with Uniswap is through providing liquidity to pools. Each pool has a set fee tier, where a percentage of each trade is transferred to the LPs. In V2, this fee is absorbed by the pool, increasing the value of the entire pool so that an LP’s X% share of the pool increases in absolute value. In V3, fees are distributed to each LP separately and must be claimed.

To be a successful LP, you must fully understand impermanent loss (IL). This loss occurs when tokens in a pool change price compared to when they were deposited. The larger the change, the larger the loss. The yield earned from providing liquidity must outweigh the losses incurred due to IL to post an overall profit. See an IL calculator here.

Potential Future Fee Sharing

The subject of sharing fees with UNI token holders has been long debated in the community, and finally the infamous Uniswap ‘Fee Switch’ is up for a governance vote. As all Uniswap contracts are non-upgradable, this fee switch has been written into the code since inception. The vote proposes to test a select number of pools, where 10% of the fees distributed to LPs are redirected to a protocol fee pool. The test will be to see if liquidity depth and volume are affected by such a disincentive to LPs. Although it is important to note the following.

All accrued protocol fees will remain “uncollected” inside each pool smart contract until governance agrees on best use for funds via a vote.

Uniswap Fees

As mentioned, Uniswap has a range of fee tiers for V3 pools (0.01%, 0.05%, 0.3%, 1%), and a flat rate of 0.3% for V2 pools. These fees are currently 100% ‘supply-side’ fees and are directed to LPs.

Uniswap Protocol Fees
Uniswap Weekly Fees.

Uniswap V2 Analytics
Uniswap V2 Analytics.

Uniswap V3 Analytics
Uniswap V3 Analytics.

Uniswap Tokenomics

The UNI token itself grants holders the right to propose and vote on changes to the protocol such as the fee switch as well as the management of the Uniswap treasury, along with some other ownership rights.

Allocations

A total of 1,000,000,000 UNI were minted at genesis and become accessible over 4 years — this allocation is as follows:

  • 60% to Uniswap community members
  • 15% of total UNI was immediately claimed as retrospective airdrop
  • 21.266% to team members and future employees with 4-year vesting
  • 18.044% to investors with 4-year vesting
  • 0.69% to advisors with 4-year vesting

Additionally, a perpetual inflation rate of 2% per year starts after 4 years to ensure continued participation in the protocol and governance.

Token Unlocks

The remaining 43% of the UNI supply is to be retained by the governance treasury, which is fully controlled by UNI holders through governance. This is vested to the treasury in accordance with the following schedule. Team, investor, and advisor allocations will undergo an identical vesting schedule.

Uniswap Vesting Schedule
Uniswap Vesting Schedule.

Is Uniswap Safe?

Uniswap, due to its non-upgradable smart contracts is one of the safest protocols in all of DeFi. The protocol has multiple audits on both its V2 and V3 products from some of the biggest names in the business.

However, when using the Uniswap protocol you must be aware of the tokens that you are trading. Due to its permissionless nature, scammers can create pools that target users. For example, a new pool is created where all the liquidity is provided by one account that owns the majority of the token supply — in this case, they can entice users to purchase the token before selling all of their supply and removing the liquidity.

Final Thoughts

In conclusion, Uniswap is a unique protocol in the DeFi space. It has enabled billions of value to be exchanged with minimal costs and without any need for intermediaries. It has seen significant growth over the past few years and this shows no sign of slowing down soon.

For those interested in participating as an LP, you must be aware of the fee structure, potential future fee reallocations, and tokenomics associated with UNI. Finally, always be sure to conduct your own due diligence when trading on non-traditional exchanges such as Uniswap. Be safe out there!