Last updated on July 11th, 2023 at 10:41 pm
In the crypto world, UniSwap is a popular decentralized exchange (DEX) that is a force to be reckoned with because of the incredible features it offers. It is currently being hosted on the Ethereum blockchain and allows its users to enjoy decentralized token swaps.
With UniSwap, Ethereum based tokens can be exchanged within the ecosystem without traders worrying about entrusting their funds with anyone unlike in a centralized crypto exchange.
Liquidity pools are also an important aspect of UniSwap, as users can lend their cryptos to the pools and earn rewards in return. How does Uniswap work?
Introduction
When crypto took the world by storm years back, centralized exchanges were born, as they were designed to allow buyers and sellers to exchange their tokens easily. These exchanges were besieged by high trading volumes and increasing liquidity levels. Though they may have been effective in their own right, there were calls for a more decentralized approach to exchanging coins.
Further, centralized crypto exchanges have been plagued with security issues, as cases of popular hacks (such as Mt. Gox) litter through the chambers of crypto history. People started clamoring for better alternatives that didn’t force users to deposit their funds into the coffers of a centralized exchange.
Another issue that can be linked to centralized exchanges is their rigorous identification issues. When the decentralized exchange idea was birthed, it was easy for people to embrace the concept.
Decentralized Exchanges (DEXs) do not need intermediaries before transactions can be done. DEXs rely on software code (in the form of smart contracts) to execute transactions. With the significant technical issues that are linked to building a DEX, it has not been easy for developers to create DEX that can rival their centralized competitors. UniSwap was one of the first successful decentralized exchanges in existence, and it is at the forefront of the meteoric rise of Decentralized Finance (DeFi).
So, What Is UniSwap?
UniSwap is a decentralized exchange that doesn’t depend on order books to make trades. That is, the price of a given crypto asset is not determined by the relationship between open buy and sell orders.
It is censorship-resistant and devoid of centralization which makes it a favorite for many users that want to exchange Ethereum-based tokens.
Since order books are not used in trades, UniSwap incorporates liquidity providers, which deposit funds to churn out liquidity pools.
Using this mechanism screams of decentralization as there is no need for an order book nor centralized interference from a custodial body. With UniSwap, ERC-20 tokens can be swapped without the traders needing an order book.
Many exchanges incorporate a listing process which may be stringent to reduce the number of tokens that can be listed in their exchange, but that is not the case with UniSwap. It means that any ERC-20 token can be launched, once it has a liquidity pool that can be accessed by traders. Consequently, UniSwap doesn’t have a listing fee attached to any token that is launched.
How Does It Function?
UniSwap functions with Automated Market Makers (AMMs), which do not need order books. AMMs are smart contracts that are designed to have liquidity pools. Traders trade against these AMMs, and those that offer liquidity to the pools earn a fee made from transactions occurring within the ecosystem. Anyone can easily become a liquidity provider by depositing a minimum of a specified amount of tokens. For every trade done in UniSwap, a fee is charged, and the fees collected are shared with the providers based on the amount they deposited into the liquidity pools.
- Liquidity Providers
These participants create markets when they deposit at least two tokens or their equivalent into a pool. They can be two ERC-20 tokens or both an ERC-20 token and ETH. It is common to see these pools filled up with stable coins like USDT, and USDC.
Once a deposit is made, liquidity providers are given liquidity tokens, which state the number of tokens they have contributed to the liquidity pool. The tokens can then be exchanged for what they represent in the liquidity pool.
Uniswap v3: What Is It?
A good feature about the UniSwap ecosystem is that it has been revised over time. It moved from UniSwap v1 to v2, and v3 is being fitted with innovations. Below are some innovations that may be added:
- Capital efficiency
Capital efficiency is an improvement that will be noticed in UniSwap v2. A common issue noticeable in a lot of AMMs is the presence of idle capital, meaning that a sizeable amount of capital is not used effectively to earn returns.
In the prior version of UniSwap, at least five billion dollars of liquidity was locked daily. Only one billion was used daily. What this means is that a lot was being left idle, earning no returns to the liquidity providers. The team behind UniSwap wanted to solve this problem.
Liquidity providers will be allowed to choose price ranges that they can easily offer liquidity for, making the process more efficient. What this means is that more liquidity will be placed in the price range that will have the highest trading volume.
- Moving Uniswap to layer 2
It is not news that the transaction fees on Ethereum have sometimes bordered on ridiculous, as they have increased drastically due to the platform’s popularity. These fees have been discouraging to the average trader.
The third version of UniSwap will also be available on Optimistic rollup, a layer 2 scaling solution. Using this option allows the platform to enjoy the security feature of Ethereum while scaling its smart contracts. Transaction fees will reduce drastically, which will increase trading volume. Transaction throughput will also be better.
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