This article walks you through the introduction of Uniswap and how it works. Uniswap is a smart contract-powered cryptocurrency exchange that allows decentralized token swaps. Uniswap is deployed on the Ethereum blockchain. The ultimate aim of Uniswap is to eliminate the trust when carrying out transactions. Two parties across the globe can send funds trustless without any intermediaries. Also, there is a concept of a liquidity pool that allows the users to earn by providing liquidity or lending. Let's walk through the detailed work of Uniswap.
Introduction to Uniswap
Centralized cryptocurrency exchanges (CEX) have been the driving force of the cryptocurrency market for years, carrying out fast and continuous transactions and enhancing liquidity. Though centralized exchanges support fast settlement and high trading volume, the need for trust has always been a concern for the end users. The funds are held by the centralized governing authority that runs the exchange before any transaction. This gave birth to the development of Decentralized cryptocurrency exchanges (DEXes) that operate on trustless protocols. DEX requires no intermediary financial bodies to conduct transactions as smart contracts drive them.
The distributed ledger technology has some inherent limitation that makes the development of DEXes a bit harder. It is so hard for the DEXes to compete with their centralized counterparts regarding trading volume and settlement time. Uniswap is the pioneer of DEX that played a crucial part in the DeFi revolution.
What is Uniswap?
Uniswap is a decentralized exchange based on Automated Market Making (AMM) protocol built on the Ethereum blockchain. Unlike centralized exchanges, Uniswap does not have any order books to carry out trades. Uniswap offers users a high degree of decentralization and censorship resistance, allowing them to make trustless, borderless transactions.
Uniswap is open source, and anyone can explore its codebase on Uniswap Github. Uniswap allows the users to swap/trade ERC-20 tokens without centralized intermediaries.
How does Uniswap work?
Leaving behind the order book mechanism for carrying out trades, Uniswap is based on a constant product market-making design, a variant of AMM. Uniswap is fueled by this AMM protocol that uses smart contracts for holding liquidity reserves. There is a concept called liquidity pools which are nothing reserves funded by liquidity providers in return for rewards. With Uniswap, anyone can add liquidity to the pools that traders can trade against. The fee paid by traders is distributed among the liquidity providers (LPs) depending on the weightage of liquidity added.
Liquidity providers play a crucial role in the trades occurring in Uniswap. First, they create a market depositing an equivalent value of two tokens. The tokens can either be ETH and an ERC-20 token or two ERC-20 tokens. Most pools are made up of stablecoins whose values are pegged to some real-life assets like USD. When the LPs add one token to the reserve, they receive Liquidity tokens, symbolizing their contribution to the pools, which they can redeem for rewards.
Let us say there is an ETH/USDT pool. When you buy an ETH for 350 USDT, you add 350 USDT to the pool for 1 ETH. This causes an imbalance in the liquidity of ETH, causing its price to go high. Now, liquidity must be added to maintain the ratio of ETH and USDT constant. Thus, LPs are rewarded for making markets constant by adding either of the tokens to the pool.
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