Decentralized Exchanges (UNISWAP)

Uniswap is a protocol for decentralized exchange of tokens on the Ethereum blockchain and is deployed as a set of smart contracts. It is completely decentralized, permissionless and censorship-resistant. Uniswap is built on the concept of liquidity pools and Automated Market Makers (AMMs).

  • A liquidity pool is a collection of funds/assets locked in a smart contract for the purpose of providing liquidity for traders to swap between cryptocurrencies.
  • An Automated Market Maker is a system that automatically facilitates buy and sell orders in a decentralized exchange. In contrast to regular market makers, AMMs function by using self-executing computer programs; smart contracts.

Over the years, Uniswap has built a series of versions, each with unique and improved from the previous one.

Uniswap V1

The first version of Uniswap was published to the Ethereum mainnet on the 2nd of November 2018 by Hayden Adams.

Decentralized exchanges were using the order book model which did not fit very well into the layer 1 blockchain protocol like Ethereum. Ether Delta, a popular DEX at the time, had an Unintuitive UX which resulted in poor user experience and lack of liquidity. Hayden developed Uniswap to solve these problems.

He applied for an Ethereum foundation grant in July 2018 which allowed for auditing of Uniswap’s smart contracts. That resulted in adding extra safety checks and reworking math operations to minimize the rounding error. He also rebuilt the user interface for better user experience.

The first version of the protocol was launched with $30,000 worth of the initial liquidity across 3 different tokens. Uniswap quickly gained a lot of traction which resulted in an initial seed investment that allowed it to work on the second version of the protocol.

Uniswap V2

In May 2020, Uniswap launched a second version of the protocol called Uniswap V2 whose main feature was the addition of the ERC20-to- ERC20 liquidity pools. Before V2, each liquidity pool had to consist of ETH as one of the currencies. For example, in order to trade from USDT to UBN, the user had to first convert the USDT to ETH then from ETH to UBN. This resulted in higher gas fees and more slippage. With Uniswap V2, traders could convert their USDT to UBN directly. Offering ERC20 –to- ERC20 pools was better for liquidity providers (LPs) since it saved them from impermanent loss. V2 also provided for on-chain price feeds and flash swaps.

On-chain price feeds ensured that there was real-time stream of financial market data.

Flash swaps meant that pair contracts could send output tokens to the recipient before enforcing that enough input tokens have been received. This was possible because Ethereum transactions are atomic therefore the entire swap could be rolled back if it turns out that the contract hasn’t received enough tokens to make itself whole by the end of the transaction.

By May 2020 Uniswap had over $1M in daily trading volume and $10-20M in provided liquidity. In August 2020 the daily trading volume reached $150M and $300M in provided liquidity due to the large number of people participating in yield farming. This saw it overtake some centralized exchanges such as Kraken.

On September 2020, Uniswap announced the launch of their token; UNI. Uniswap wanted to further decentralize the protocol by making it a publicly owned, self-sustainable financial infrastructure while still continuing to protect its autonomous qualities. The token holders would be able to participate in Uniswap’s governance by voting on different proposals or delegating their votes to a third party. For example, UNI holders could vote to add more incentivized pools after an initial 30-day governance grace period is over.

Some of the UNI tokens were retrospectively allocated after the launch. Anyone who had used Uniswap even once before the 1st of September was eligible to claim their 400 UNI tokens that were worth $3 each at the time. A couple of days later, the UNI tokens were traded across centralized and decentralized exchanges with the token price going as high as $8, making the initial 400 UNI reward worth around $3200. The tokens were distributed to around 50,000 Ethereum addresses. The liquidity providers were also rewarded with extra UNI tokens. A total of $1B UNI tokens were allocated to various groups. Uniswap also announced four incentivized liquidity pools that would be rewarding liquidity providers with extra UNI tokens which resulted in attracting millions of dollars of new liquidity.

In August 2020 Uniswap raised $11M from a few notable VCs including: Andreessen Horowitz, Version 1 and USV which was used to develop Uniswap V3 which would increase the flexibility and capital efficiency.

Uniswap V3

Uniswap V3 focuses on maximizing capital efficiency compared to V2. This not only allows liquidity providers to earn a higher return on their capital, but also dramatically improve straight execution that can compare or even surpass the quality of both centralized exchanges and stablecoin-focused AMMs. In addition, because of better capital efficiency, LPs can create overall portfolios that significantly increase exposure to preferred assets and reduce their downside risk. They can also add single assets as liquidity to a price range that is above or below the current market price which creates a fee earning limit order. This is all possible through concentrated liquidity. V3 also introduces multiple fee tiers and improves Uniswap oracles.

Uniswap V3 features:

  • Concentrated liquidity – liquidity can be allocated to a specific price interval, resulting in a concentrated liquidity position. Concentrating liquidity around the current price, as well as updating custom positions according to the price changes, is an effective strategy that is aimed at maximizing gains while exposing far less capital to the risk of asset devaluation.
  • Active liquidity – leverages a broad set of automated processes and analytical insights to achieve better financial outcomes
  • Range orders – liquidity providers can open as many positions in the pool as they wish, thereby creating unique price curves aligned with their personal view of the market. The tighter the range that is set for a concentrated liquidity position, the greater fee revenue that is earned and vice versa.

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