Originally published in the NOWNodes blog.
The yearn.finance (YFI) token has grown in price from $34 to over $35,000 in just a month and a half. Chainlink LINK jumped from $4.12 to a peak of $19.8 in two months, but then experienced a rebounce to $12. What do these coins have in common? In addition to envy of early buyers who bought coins for pennies, the latter also have a common place of sale. All of them are also sold on the Uniswap decentralized platform.
Uniswap is an Ethereum-based decentralized exchange that allows anyone to exchange their ERC20 tokens among themselves. This can be done by everyone, and for transactions you do not need registration, identity verification and other things that the exchange usually requires. The Uniswap protocol was created by Hayden Adams, who in turn was inspired by the publication of Vitalik Buterin.
The peculiarity of ERC20 tokens is that the coins on this standard are interchangeable, that is, they are essentially equal to each other within the Ethereum blockchain. This allows you to exchange them without any problem.
Uniswap was created to address the liquidity problem faced by conventional cryptocurrency exchanges. Liquidity itself is the ability to sell any stock of coins on the platform without significantly affecting the price, which requires a large number of buyers and sellers. To understand the term, you need to remember how crypto exchanges work.
Let’s say you want to buy 100 ethers at $5000. To do this, you place a buy order, after which the exchange starts looking for orders to sell ETH for $5000 or less. If the volume of sell orders exceeds the required amount of 100 ethers, then the order is executed and the coins are sold. If there are too few sellers — that is, there is not enough liquidity – the order is not fully executed. Well, if there are no response orders, then the original order is sent to the order book.
Uniswap does not have this – it creates the market automatically, which is why transactions are carried out almost instantly. Actually, because of this, it is called AMM, or automatic market maker, with which we are already familiar.
It is important to understand that to exchange coins on a regular exchange, you need to replenish your wallet with coins, place a trade order — that is, indicate the desired cryptocurrency and the required volume, and then withdraw funds. Uniswap eliminates all of these steps. With it, it is enough to send coins from your wallet to a specific address and receive the necessary tokens in return.
How Uniswap works
How to achieve such a result, when transactions for any pair are carried out instantly, everything is done without a centralized authority, and users do not need to register? This is helped by the main components of Uniswap — smart contracts and liquidity pools. Let’s deal with them one by one.
Smart contracts are programs in a specific blockchain with a previously described principle of operation. The points of the latter are carried out alternately and without question, but for this a certain condition must be met. In the case of Uniswap, we are talking specifically about the exchange of tokens, which is performed automatically and without the participation of people.
The work of smart contracts on the example of Uniswap: if a user sends ether in exchange for the necessary tokens, she will definitely receive them. The main thing is that the wallet has the required amount and, in addition, there is enough money for the commission. Without these conditions, the swap — that is, the exchange — will not begin and will not take place.
By the way, since Uniswap operates on smart contracts, transactions require more gas than a regular transaction. Accordingly, the exchange will cost more than a simple transfer – and this is the norm.
Moving on to liquidity pools. This concept can be conceived as reserves of tokens in smart contracts that are available to users and allow transactions with them. After all, if certain coins are not blocked within the protocol, it will not be possible to buy them corny.
A feature of Uniswap is the requirement for the volume of tokens within a trading pair, which must be in equilibrium in the liquidity pool. In short: developers cannot fill the liquidity pool for their projects exclusively with their own tokens, since this goes against the rules of the automatic market maker. The essence of the latter lies precisely in the constant maintenance of the balance, taking into account the amount of liquidity on different tokens paired with Ethereum. It turns out that liquidity providers must also add the equivalent of the amount of tokens in ETH.
Who trades on Uniswap
There are two main parties to Uniswap – buyers and liquidity providers. With the first, everything is clear: they connect their cryptocurrency wallets (most often it is MetaMask), choose the desired coin, indicate the desired purchase volume, set the cost of gas for swap, pay commissions and receive new coins.
At the same time, liquidity providers enable traders to exchange coins among themselves and make money on it. Anyone can become a liquidity provider: for this you need to provide a certain token and an equivalent amount of ether at the current exchange rate of the platform. That is, in fact, you need to fill the already mentioned cell, from which other users will take tokens.
Providers of liquidity earn on commissions – from each transaction they are deducted 0.3% of the trading volume. This encourages providers to share tokens and keep the platform running smoothly.
That is, in fact, Uniswap is also a good opportunity to earn passive income from tokens that are idle. Again, there are no restrictions on the platform: anyone can become a liquidity provider.
Uniswap is the next step in the development of cryptocurrency exchanges. The platform works in a decentralized manner and at the same time perfectly fulfills its tasks. Its user base, against the backdrop of the boom in popularity of the decentralized finance niche, grew at least twice in August compared to the previous month, and the indicator clearly does not plan to stop.
The exchange is doing an excellent job and works flawlessly. Yes, it is seriously consuming the resources of the Ethereum network, but this is a cost of the current market situation. So in the end, Uniswap deserves praise and recommendation for use.