What is Uniswap – A Beginner’s Guide (2021 Updated)

What is Uniswap? How is it different from
traditional cryptocurrency exchanges? And what is this UNI token that’s
been rocketing up the price chart? Well stick around,
here on Crypto Whiteboard Tuesday, we’ll answer these questions
and more. Hi, I’m Nate Martin
from 99Bitcoins.com and welcome to Crypto
Whiteboard Tuesday where we take complex
cryptocurrency topics, break them down and translate them
into plain English. Before we begin, don't forget to subscribe
to the channel and click the bell so you’ll
immediately get notified when a new video comes out. Today’s topic is Uniswap
and the UNI token. It’s important to note
that this is an advanced topic that relies on prior knowledge
of how cryptocurrencies work. If you’re new to crypto you may want to check out
additional videos that we’ll mention and link to
in the description to get you up to speed.

Now let’s get started. Uniswap is a decentralized,
permissionless exchange that allows anyone to trade
Ethereum ERC-20 tokens directly without the use of a middleman. OK…what exactly did I just say? Don’t worry: we’re going to
work through this together. To understand
what makes Uniswap different, let’s start out by taking a look at how
a traditional cryptocurrency exchange, like Kraken or Bitstamp works. To begin with,
traditional exchanges are centralized, meaning they are owned
by a company that has complete control
over the exchange and the computers that run it. Traditional exchanges
are also regulated by KYC laws, which is an abbreviation for
‘Know Your Customer’. These laws require
each new customer to provide extensive
personal information, including your home address
and tax ID numbers before you can begin trading
on the exchange.

Additionally, in order to trade
on a traditional exchange, users need to deposit money
on the exchange, basically giving the exchange
control over their funds. On a traditional exchange, when users want to buy or sell
a certain cryptocurrency they submit a “Buy” or “Sell” order. All of these orders are recorded
in the exchange’s order book. Once there’s a match
between a buyer and a seller, a trade is conducted. So this is how a traditional,
centralized exchange works. If you want to learn more
about exchanges and trading, you can check out our
“What is Bitcoin trading” video which we’ll link to below. Now let’s talk about
decentralized exchanges, also known as DEXs. DEXs are part of the decentralized
finance ecosystem. Decentralized finance,
or DeFi for short, is a term given to traditional
financial services such as exchanges,
lending services, and insurance, that have been decentralized through the use
of Blockchain technology. If you’re not familiar with DeFi
or Blockchain technology you can also check out
these two videos. We’ll leave the links
in the description Now, unlike a traditional exchange that requires a controlling company
and centralized servers to operate, A DEX consists of a set of smart
contracts deployed on a blockchain.

In simple terms,
it’s a set of automated rules that are executed by a network
of independent computers without any central entity controlling it. And if you want to learn more
about smart contracts and how they work, you can take a look at our
“What is Ethereum” video. Since DEXs aren’t controlled
by anyone, they can’t be regulated
and are in fact open to everyone. When using a DEX
there’s no need to open an account, or go through an identification process where you’d have to supply
your personal information. Additionally DEXs allow users
to trade directly from their own wallets allowing them to keep full control
over their funds. A key difference a DEX has
from a traditional exchange is in the way transactions
are conducted and how price is determined. As I’ve mentioned earlier, in a traditional exchange buyers and sellers set
their price expectations as “Buy” and “Sell” orders
inside the order book.

The more buyers and sellers
an exchange has, the larger its order book and the more “liquid”
the exchange is said to be. In other words, it’s easier to find a buyer and a seller
that agree on a price and make a trade. Imagine there are only 2 buyers
and 2 sellers on a certain exchange. It would be very hard for any trade
to get executed, since it's unlikely to find two people
who would agree on a price. Without liquidity
the exchange is practically dead since no trades can be conducted. It’s the same as having a shopping mall with very few stores
or and customers. There’s not a lot of business
that will be done there. In fact, liquidity is such
an important criteria to determine the quality
of an exchange, that some exchanges use
external services called “market makers” that are willing to buy and sell
at all times, creating constant liquidity
for the exchange. DEXs, on the other hand,
don’t store any user funds and have no order book. Liquidity on DEXs is created
through liquidity pools. Liquidity pools are
a shared pot of funds deposited by the general public, and DEXs use liquidity pools
in order to fulfill “buy” and “sell” orders.

People who deposit funds
in liquidity pools are known as liquidity providers
or LPs. In exchange for the locked funds, LPs receive a part
of the DEX’s trading fees in a process known as
liquidity mining. Now that we’ve covered
the differences in how liquidity is provided between
traditional and decentralized exchanges, let’s talk about how the price
of a certain coin is determined. On a traditional exchange, when a seller and buyer reach
an agreement through matching orders
in the exchange order book, a trade is conducted. At that point the price of the coin
is determined until another trade is executed
at a different price. In other words, the price of the most recent trade
is considered the current price on the exchange. A decentralized exchange
on the other hand, doesn’t have an order book. Users don’t trade with one another, they trade within a liquidity pool. And instead of using the last trade
to determine the price, a mathematical formula is used.

This formula, or algorithm,
is called an Automated Market Maker or AMM for short. Uniswap uses an AMM called
“Constant Product Market Maker Model” to determine the price of coins
on its exchange. This AMM follows a simple formula
of X times Y equals K. This means that when trading,
for example, Ether for DAI the amount of Ether available
times the amount of DAI available on Uniswap’s Ether/DAI liquidity pool
should always equal a constant number. Let’s break this down a bit further. Imagine there are 10 ETH
and 10,000 DAI on a certain liquidity pool. As we can see,
using the AMM model this means that the number of ETH times the number of DAI equals 100,000,
this is our constant K.

If I were to buy 1 ETH, this will reduce the number of ETH
in the pool to 9. Now the question remains,
how many DAI will this cost. Well, the way to calculate this
is to take our constant of 100,000 and divide it
by the new number of ETH, 9. This would give us the new number
of DAI required in our pool – 11,111. Meaning we need to deposit
around 1,111 DAI to buy one ETH. As you can see the price is determined by how much of a certain token
you want to buy, and not by how much someone else
wants to get for it. By using the “Constant Product
Market Maker Model” algorithm, liquidity is kept without the need
for external market makers, no matter how large the order size
or how tiny the liquidity pool.

This model makes it infinitely expensive to consume the whole amount
of a certain coin, putting a damper on larger orders. For example,
In our previous exercise, if I wanted to buy 9 ETH
it would cost me 90,000 DAI to maintain the 100,000 constant, making each ETH cost 10,000 DAI
instead of the 1,111 DAI it would cost to buy only 1 ETH. Of course there are other DEXs
with different AMM algorithms than the one used on Uniswap, but that conversation goes beyond
the scope of this video.

Now that we’ve covered DEXs we can focus on Uniswap more in depth. Uniswap is a DEX built on top of
the Ethereum network infrastructure. It’s a set of automated rules
used for trading ERC-20 tokens, which is a term given to a certain
standard of Ethereum tokens. Uniswap is the most popular
decentralized application, or DAPP, on the Ethereum platform with hundreds of thousands of users
trading on it each week.

Additionally Uniswap is one of
the most forked projects in the DeFi space, meaning people use its code
to build additional applications. The first version of Uniswap
started out in November of 2018. Uniswap’s V1 allowed trading
of any ERC-20 token to Ether and back. In May of 2020 V2 was released and the trading of ERC-20 tokens
directly between one another without first having to trade with Ether
became available. In May of 2021 V3 was released allowing a more effective use of capital to whoever decides to supply
liquidity to Uniswap. In other words you can squeeze more “juice”
out of the money you deposit in the liquidity pool. Trading also got more efficient, lowering trading costs compared to V2. Additional changes which we won’t
go into in this video include concentrated liquidity,
active liquidity, range orders, flexible fees and more. So how do you actually use Uniswap? Well, it’s fairly simple, all you need is an Ethereum wallet
like Metamask which can interact
with other Ethereum applications. Once you have Metamask
installed on your browser, head over to Uniswap.org,
click on “Connect Wallet”, choose “Metamask” and now you can start trading
any Ethereum ERC-20 token that is listed.

Keep in mind that since there are
many people conducting trades on Uniswap simultaneously, the price shown
when you place your order may be different from the actual price
when the order is executed. This phenomenon is called “Slippage” and you are able to cap
how much slippage you are willing to tolerate
before cancelling your order. The reason for slippage is that every trade on Uniswap
is actually an Ethereum transaction and it can take some time
to broadcast the transaction and get it confirmed
by the Ethereum network. By the time the transaction
is confirmed, the price may have already changed. Due to its decentralized
and non-regulated nature, Uniswap supports many types
of ERC-20 tokens. In fact, practically anyone
can create their own token and list it on Uniswap for free, filling Uniswap with a wide variety
of tokens but unfortunately a fair number
of scam coins as well.

Just because a coin is listed
on Uniswap doesn’t mean it’s legit
or has any intrinsic value. As opposed to a traditional exchange that does extensive due diligence
and research on every coin it adds to its platform ,
Uniswap doesn’t. So – it’s up to you to Do Your
Own Research as they say and decide if you want to invest
in a certain coin. Finally, let’s talk about the UNI token. A coin that has gradually made its way
to the list of top cryptocurrencies. In September of 2020 Uniswap introduced the UNI token
through an airdrop. Meaning, each person
who previously used Uniswap received 400 UNI tokens for free. Even though the UNI token
has risen substantially in value since its release, it wasn’t designed to serve
as a currency.

It’s actually a governance token, allowing whoever holds it to influence
and vote on development decisions. The more tokens you hold,
the more voting power you have. The idea is for the Uniswap team
to gradually fade out their involvement in Uniswap and leave the management
of the project to the token holders. So how is it that a token that wasn’t meant to have any value
rose to the top of the cryptocurrency list? Well…it seems that the price of UNI represents how valuable people believe
that Uniswap will be in the future, and therefore are willing to pay
to be a part of its governing body. In the cryptocurrency space it’s not uncommon for coins that never had any intention
of being used as a financial asset to become very valuable. In the end it’s up to you to decide if being a part of the Uniswap
governing body is worth the price of the UNI token.

That’s it for today’s episode
of Crypto Whiteboard Tuesday. Hopefully by now you understand
what Uniswap is – a decentralized exchange that allows users to trade
any ERC-20 token without any intermediary. You may still have some questions. If so, just leave them
in the comment section. Finally, if you’re watching this video
on YouTube, and enjoy what you’ve seen, don’t forget to hit the like button, subscribe to the channel and click that bell so that you’ll be notified
as soon as we post new episodes. It really helps us out a lot.

Thanks for joining me
here at the Whiteboard. For 99bitcoins.com, I’m Nate Martin,
and I’ll see you…in a bit..

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