Uniswap is an Ethereum-based decentralized exchange that allows anyone to swap ERC-20 tokens. The leading DeFi platform aims to solve one of the major issues faced by DEXs - lack of liquidity. In 2021, Uniswap became the first DEX to process trades worth over $100 billion.
WHAT IS Uniswap?
DEXs offer users financial products such as loans, insurance and derivatives in a decentralized and non-custodial manner. This effectively replaced middlemen in offering financial services which is the norm in centralized exchanges.
While DEXs solve many of the problems faced by centralized institutions, including risk of hacking, mismanagement of funds and arbitrary charges, they also face their own challenges. The one major challenge faced by DEXs is lack of liquidity – a situation where the exchange lacks the amount in its reserves to make faster and cheaper transactions.
Uniswap solves the problem of liquidity by allowing exchanges to swap ERC-20 tokens without relying on buyers and sellers creating the liquidity.
HOW DOES IT WORK?
What makes Uniswap stand out from other decentralized exchanges is its pricing mechanism called the “Constant Product Market Maker Model”. This mechanism allows any ERC-20 token to be added to the exchange by funding with the equivalent amount of Ethereum (ETH) and ERC-20 token.
For example, if a user wants to exchange for an ERC-20 token, they would launch a new smart contract on the platform for the token and create a liquidity pool with equal amounts of the ERC-20 token and ETH.
Instead of buyers and sellers determining price of the tokens, Uniswap uses an equation that will find a balance between the supply and demand of the ERC-20 and ETH tokens to determine the price. So, When a user wants to swap a token with ETH, the supply of the token decreases while the supply of ETH increases, resulting in the price of the swapped token to rise.
SMART CONTRACT AND LIQUIDITY POOL
Uniswap allows permissionless trade of any ERC-20 token. Each token listed on the exchange will have its own smart contract and liquidity pool which can be created easily.
Once the ERC-20 token gets its own smart contract and liquidity pool, anyone holding the token can trade or contribute to the pool by providing liquidity in the token and its equivalent amount of ETH. Pool contributors will earn a liquidity provider fee of 0.3% in the platform’s UNI token.
Uniswap has been updated several times over the years and now has V2 and V3. Updated versions of the DEX integrates more features like :
– Direct ERC-20 to ERC-20 swaps
– Added support for Tether USD (USDT)
– Concentrated liquidity – allowing liquidity providers to allocate liquidity within a custom price range.
– Easier and cheaper Oracle – allowing smart contract to confirm transactions by verifying off-chain data
In 2020, Uniswap launched the network’s native governance token, UNI. The protocol has planned a total distribution of 1 billion UNI tokens over four years. 40% of the tokens were distributed in the first year and the percentage will come down by 10% in the subsequent years. The tokens are distributed as follows:
– 60% allocated to the community
– 21.5% allocated to Uniswap employees
– 18% allocated to investors and advisors
As a governance token, UNI allows holders to vote in decisions regarding how the protocol is run. The tokens also offer holders immediate ownership of Uniswap governance, the UNI community treasury, the protocol fee switch, ETH ENS, the Uniswap Default List of tokens and SOCKS liquidity tokens.
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