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What Is Uniswap (UNI) and How Does It Work?

By Colin Dodds · September 08, 2021 · 5 minute read

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What Is Uniswap (UNI) and How Does It Work?

What is Uniswap?

Uniswap is an open-source software protocol built on the Ethereum blockchain that allows investors to make decentralized cryptocurrency trades. What makes Uniswap unique is that it allows users to trade cryptocurrency directly with one another without intermediaries. And because it’s open source, virtually anyone can create a decentralized exchange using their code.

The Uniswap exchange has also garnered attention because of the UNI token, a new cryptocurrency that serves as its native governance token.

Why Decentralized Trading Matters for Crypto

These days, most cryptocurrencies are traded on centralized exchanges, with Binance and Coinbase being two prominent examples. That wasn’t always the case; in fact the concept of decentralization was core to the inception of cryptocurrency itself back in 2009.

From the outset, blockchain technology was and is essential to most forms of crypto. It’s also known as distributed ledger technology. This ledger exists on a host of independent computers around the globe, which are often called nodes. Each node tracks and coordinates transactions. This differs from more traditional investment trading models, which typically rely on a clearing house or exchange and track all trades in a central ledger.

How Does Uniswap Work?

Like many digital trading platforms, Uniswap facilitates the buying and selling of cryptocurrency assets using blockchain smart contracts. And like some other cryptocurrency networks, Uniswap is decentralized, meaning that a network of users test and verify the validity of each transaction by comparing the millions of copies of the same smart contract for each token. In fact, Uniswap is the fourth-largest decentralized finance platform (or DeFi, in crypto lingo).

Since Uniswap permits users to directly trade cryptocurrency with one another, the Uniswap program promotes speed and reliability. To provide that level of efficiency, Uniswap relies on an automated liquidity protocol.

What Is an Automated Liquidity Protocol?

The automated liquidity protocol is an automated market-making algorithm in which a Uniswap liquidity pool creates its own tokens, each one of which consists of two reserve ERC-20 tokens. The ERC-20 is considered the technical standard for all smart contracts on the Ethereum blockchain, and it defines a common rule all Ethereum tokens must follow.

Uniswap’s unique two-for-one ERC-20 structure allows anyone holding Ethereum tokens to act as a liquidity provider for a Uniswap liquidity pool. To do so, all they have to do is purchase liquidity-pool tokens.

The pool tokens track shares of the total ERC-20 reserves, and can be redeemed for the underlying tokens at any time. The traders who provide liquidity receive a fee for doing so, which is based on their contribution to the pool.

The liquidity providers can create their own pools, with the first liquidity provider setting the starting price for the assets in the pool. Because traders pay a fee to the liquidity pool for using it, the total amount of money in a pool increases slightly with every trade, which is what makes it profitable for liquidity providers.

Who Uses Uniswap?

Because these pool tokens each consist of two reserve ERC-20 tokens, they act as automated market makers, and can allow for bigger, faster trades. While these trades take place without a formal intermediary, Uniswap charges a 0.30% fee to trades. That fee goes into its reserve pool, however, which serves as a payout to liquidity providers.

Some cryptocurrency investors see Uniswap as a way to earn income. There are a handful of Uniswap liquidity providers who passively invest their assets in the liquidity pool to earn trading fees on the side. And there are also some Uniswap users who are building a business as market makers, using Uniswap and other software, and will develop custom tools to track their positions across different cryptocurrencies.

At the same time, software developers and other entrepreneurs are using Uniswap to develop new liquidity strategies, such as incentivized liquidity, or liquidity as collateral, which could power the next generation of cryptocurrency development.

At the same time, speculators use Uniswap to trade tokens using its liquidity pools. Some of these speculators use arbitrage bots that compare prices across different platforms to profit from price discrepancies.

Recommended: Crypto Arbitrage: How It Works & Trading Strategies

How to Use Uniswap

To use Uniswap you’ll first need to acquire an Ethereum Wallet and some ETH tokens. An Ethereum wallet is a software application that allows you to interact with your Ethereum account, check your balance and trade ETH tokens.

These crypto wallets come in different forms. Some are physical hardware wallets, like USB drives, which allow you to keep your tokens offline and secure from hackers and other cyber threats. Other wallets consist of mobile applications; the advantage of these is that you can tap your crypto assets from anywhere. There are also wallets that let you view and access your account online, or via a desktop application.

Recommended: Cold Wallet vs Hot Wallet: Choosing the Right Crypto Wallet

Most wallets act like a banking app, but there is no bank. You can change wallet providers without moving your assets, and many wallets allow you to manage several Ethereum accounts at the same time. That’s because the assets are identified and verified by their underlying blockchain, rather than a bank.

Once you have your Ethereum wallet set up, you can connect it to the Uniswap app, which will allow you to start using the software protocol to provide liquidity and earn the liquidity fee, or to swap tokens.

Uniswap and the UNI Token

Uniswap has also generated its own form of cryptocurrency, called the UNI. As of February 20, 2021, it was the 24th most-held cryptocurrency, according to Coinbase, with a market cap of $9.4 billion. By contrast, the largest cryptocurrency, Bitcoin, had a market cap of $1.1 trillion, and Etherium, the second-largest, had a market cap of $229 billion.

But the size and success of the UNI is especially impressive, given that it only launched in September of 2020, when it sent 400 UNI to every user on its network (a payout worth more than $12,000 as of February 20, 2021). The UNI plays a key role in the Uniswap network. UNI holders vote on proposals about the development of the software protocol and its ecosystem. Anyone who wants to submit a proposal about changes to the Uniswap network must own at least 1% of the total UNI supply.

As launched, the UNI was available only to traders involved in maintaining Uniswap liquidity pools, with 60% of the original UNI supply allocated to those users. Traders who provide liquidity can be paid their fees in UNI.

But investors don’t need to be liquidity providers on Uniswap in order to buy UNI tokens. There is currently an active secondary market for them, with 305 million tokens in circulation, according to Coinbase.

The Takeaway

Although most cryptocurrencies are traded on centralized exchanges like Binance and Coinbase, Uniswap — a protocol built on the Ethereum blockchain in 2018 — is fully decentralized. It’s designed for fast and efficient trades, and users can trade with each other sans intermediaries.

You could start investing in crypto with SoFi today by opening a brokerage account with SoFi Invest®. SoFi Invest offers an active investing solution that allows you to choose your stocks and ETFs without paying commissions. SoFi Invest also offers an automated investing solution that invests your money for you based on your goals and risk, with no SoFi management fee.

Photo credit: iStock/Vertigo3d

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