Did you know that over $620 billion worth of crypto was traded on Uniswap in 2022?
There were also more than 68 million transactions on the platform during the same period.
So, just how did UniSwap become one of the most influential crypto exchanges in the world?
In this article I’ll dive into this question and demystify what Uniswap is, explaining how it works and what makes it a core part of the crypto world.
So, What is Uniswap?
Uniswap is a decentralized exchange that allows users to swap Ethereum-based tokens at very low fees.
But what turned Uniswap into such a big deal?
After all, there are many ways to exchange crypto for cash out there...
Well, to begin, let’s consider a simple analogy.
Suppose you were a cheese maker centuries ago before modern commerce began.
You've produced more cheese than you can eat, so you head to the village and find another farmer to trade with.
Since you can’t live on cheese alone you decide to get some potatoes, and you offer the potato farmer a deal.
For every kilogram of potatoes they give you - you agree to give them two kilograms of Cheese in exchange.
Everybody agrees, you make the trade and go back home with a sack of potatoes.
This cheese and potato trade is what we call a Classic Swap.
What is a Classic Swap in Uniswap terms?
Let’s imagine that the Cheese is Ethereum tokens and the Potato is DAI tokens.
Uniswap basically allows users to swap different cryptocurrencies directly - without going through intermediaries or other third parties.
In turn, this allows the platform to offer lower transaction fees.
Also, perhaps more importantly, Uniswap is fully decentralized.
This means there is no single person or entity that has any power over how the platform works.
Then, What Are the Core Concepts Behind Uniswap?
To better understand how Uniswap works, let's fast-forward the cheese and potato trades into the modern day.
Nowadays, if you are a cheese farmer and want to get some potatoes, you don't need to find a potato farmer down in the village anymore, right?
You simply need to sell your surplus cheese and get dollars in return.
After that, you head over to the supermarket and buy the potatoes you need.
You don't need to know where the potatoes come from or who farmed them. The supermarket takes care of all of that.
The vice versa is also true for the potato farmer who wants some cheese.
In a sense, Uniswap is a supermarket that allows you to exchange goods directly - instead of using dollars.
You just take your goods to the supermarket and exchange them for some other goods that you want.
OK, How does Uniswap Actually Work?
For the supermarket to be able to serve the cheese farmer and the potato farmer at any time, they need enough cheese and potatoes stored up.
That way, even if someone comes with a lot of potatoes, there’s still enough cheese to go round.
Applying this to crypto, Uniswap works by maintaining stores of tokens that traders can trade against.
These stores of tokens are called liquidity pools.
For the Ethereum and DAI trades, Uniswap needs to have enough of both tokens available so that users can exchange - or swap - them without any issues.
But it begs the question, how does anyone know what anything’s worth?
How Does Uniswap Determine Token value?
Well, all this is determined by the activity on the liquidity pool.
Let's say, for example, there is a pool of Ethereum and DAI tokens, right?
Let’s also assume that in this pool, there are 100 Ethereum tokens and 100 DAI tokens, with the swap ratio at 1:1. This basically means that one Ethereum token can be swapped for one DAI token.
The ongoing value of Ethereum against DAI in this liquidity pool is determined by demand and supply.
For instance, if a user swaps 10 DAI tokens for 10 Ethereum tokens at this 1:1 ratio, it means the pool now has 110 DAI tokens and 90 Ethereum tokens, right?
Because there is less Ethereum in the pool now, it means the next user won’t be able to swap using the same 1:1 ratio.
In order for the system to balance out, they will be offered more DAI for less Ethereum. In this specific example, the swap ratio is around 0.8:1, meaning 0.8 Ethereum tokens get you 1 DAI token.
This ratio continues to change depending on what users are swapping in the pool.
So, for example, if it reaches a point where the pool has 10 Ethereum and 190 DAI tokens, the 10 Ethereum tokens clearly become much more valuable.
This is essentially how the value of token swaps is determined on Uniswap, too.
But... Where does Uniswap Get Its Liquidity?
The tokens available on Uniswap liquidity pools basically come from its users.
Let’s say, for example, you are an investor in DAI and you own 300 of these tokens.
Instead of just holding these coins in your wallet, you can put them in an Ethereum-DAI liquidity pool on Uniswap.
As such, users who put their tokens in these pools are known as liquidity providers or LPs.
All liquidity providers earn a portion of the fees that Uniswap charges users to do swaps.
This gives you a very easy way of earning passive income from your crypto holdings.
The risk, however, is that you must agree to lock these tokens into the liquidity pool for a specified period of time.
This could work out badly if there is a downturn in the market, as you may not have enough time to offload your coins and cover your losses.
It’s not all doom and gloom though!
What are Uniswap's Advantages Compared to Traditional Exchanges?
Firstly, Uniswap is fully decentralized.
This means that the community runs the platform, and there is no central person or entity that can veto transactions or influence how swaps are done.
In this sense, it offers a level of autonomy that crucially builds trust.
Furthermore, Uniswap truly makes the concept of converting crypto to crypto an affordable one.
Think about it this way. If you use a centralized exchange to convert Ethereum into DAI, you need to first exchange the Ethereum tokens into dollars, incurring some fees.
Then, you use these dollars to buy your DAI tokens, paying further fees along the way.
All in all, it’s a pretty expensive route to go down.
With Uniswap, however, overall fees can remain very low.
As Uniswap runs on smart contracts, its entire system operates through code and executes automatically without additional input from humans.
It means there are less people to pay on the way, but it also creates a new level of transparency and accountability - for other exchanges to live up to!
Of course, no crypto project would be complete without its own token, right?
So, What About the UNI token?
As we have noted above, Uniswap is a decentralized exchange governed by its community.
However, for you to become a bona fide member of the Uniswap community, where you can actually influence how the platform is run, you need to own the UNI token.
This is basically a cryptocurrency where holders get the power to steward, govern, and influence how Uniswap works.
The Uni Token also allows people who are actually enthusiastic about Uniswap to get a stake in its business.
In buying the UNI token, holders are essentially investing directly in Uniswap’s future.
However, even the best-planned projects don’t always get everything right...
Are there any Downsides to Uniswap?
For all its positive aspects, the platform is not 100% perfect.
For starters, you cannot use fiat currency or traditional money to buy crypto on the platform.
In fact, Uniswap only allows the exchange of crypto for crypto. For someone who is new to the crypto world, this procedure can be very confusing.
Besides, Uniswap does not have strict KYC requirements.
There is no knowing who is using the platform or whether they are bad actors or not. While this is great for anonymity, it does create some potential legal issues in the future.
Conclusion
In this article, you took a deep dive into Uniswap, one of the most significant decentralized exchanges in the crypto world.
You saw how Uniswap operates, using a cheese and potato farmer analogy to explain the concept of swapping, liquidity pools, token value and the role of liquidity providers.
The benefits of Uniswap are on show too, particularly in regard to decentralization, low fees and transparency.
You also got an introduction to the UNI token, the fuel that gives the Uniswap community its power and influence over the platform and its direction.
It’s also important to remember that there are some downsides to Uniswap too, such as its inability to use currencies and the absence of KYC requirements. This may lead to reduced adoption even as the platform continues to operate.
But basically, Uniswap has greatly impacted the crypto landscape, with its low fees and decentralized approach it’s clear why it has become such an important part of cryptocurrency exchange.
