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

By Colin Dodds · December 02, 2021 · 8 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

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

Uniswap is an automated decentralized crypto exchange (DEX). It runs on the Ethereum blockchain, and its governance token is the UNI.

Unlike centralized crypto exchanges like Binance or Coinbase, the Uniswap protocol uses smart contracts to enable cryptocurrency transactions and trades. Uniswap was one of the first DEXs to create an automated liquidity protocol to facilitate trades.

Learn how Uniswap’s innovations have furthered the evolution of decentralized finance — a.k.a. DeFi — what it means for potential investors, and how the UNI token fits into the picture.

What Is Uniswap?

Uniswap is an open-source software protocol built on the Ethereum blockchain that allows investors to make automated cryptocurrency trades. What makes Uniswap unique is that it allows users to trade cryptocurrency directly with one another without intermediaries, using an automated liquidity protocol rather than the standard order-book structure for buyers and sellers.

Automated liquidity pools also help solve the liquidity problem common on centralized exchanges, where trades depend on having enough volume to meet the needs of buyers and sellers. Uniswap users are incentivized to pool their money in a fund that theoretically any trader can draw upon to complete a trade (more on this below). Because traders can buy and sell many different types of crypto, each token listed has its own liquidity pool; the prices are determined by smart contracts.

The people who pool their money — the liquidity providers, or LPs — are rewarded with tokens that portion they contributed to the fund (say 1%), which can then be redeemed for that percentage of the trading fees generated by that pool.

And because Uniswap is open source, virtually anyone can create a decentralized exchange using their code.

Why Decentralized Trading Matters for Crypto

These days, most cryptocurrencies are still traded on centralized exchanges, with Binance and Coinbase being two prominent examples. Centralized exchanges like these are run by the company that owns the platform (a central authority), and often rely on a traditional order book system for trading. Also, users must place funds under the platform’s control, which can require handing over private keys to exchange crypto.

This runs counter to the concept of decentralization, which is foundational to the inception of cryptocurrency itself. By definition, most cryptocurrencies are decentralized: meaning, they are not created or managed by a bank, government or other central authority.

Cryptocurrencies are built on blockchains. Blockchain technology is also known as distributed ledger technology. This ledger exists on a host of independent computers around the globe, typically called nodes. Each node tracks and coordinates transactions on each crypto platform (e.g. Bitcoin, Ethereum, Litecoin, Dogecoin, Uniswap, and more), which are then appended to the blockchain in chronological order. Because the verification of transactions is decentralized in this way, it creates a system of checks and balances within the platform that in effect makes each form of crypto self-governing.

Given the decentralized nature of most crypto, it makes sense that decentralized exchanges like Uniswap and SushiSwap have been emerging.

History of Uniswap

The Uniswap platform was created in 2018 by Ethereum developer Hayden Adams. The project was built on top of the Ethereum blockchain, and was reportedly born out of a desire to bring AMMs (or automated market makers) from Ethereum to more users. Uniswap is also compatible with all ERC-20 tokens, the standard used for creating smart contracts on Ethereum.

The Uniswap token, UNI, is Uniswap’s native governance token. Tokens of this nature give those who hold it the power to cast votes on proposed new changes to the platform.

UNI was created in September 2020 as an incentive for people to stay on the Uniswap platform instead of migrating to SushiSwap, a fork of Uniswap and a competing decentralized exchange (DEX). A month prior to the UNI token release, SushiSwap had encouraged Uniswap users to move over to SushiSwap by rewarding those who did so with SUSHI tokens. The SUSHI tokens were a new type of governance token that would also give users a part of the transaction fees generated by the platform.

In response to this development, Uniswap decided to create 1 billion UNI tokens and distribute 150 million of those tokens to all those who had previously used the platform. Each individual received 400 Uniswap tokens.

How Does Uniswap Work?

Like many digital trading platforms, Uniswap facilitates the buying and selling of cryptocurrency assets using smart contracts. And like some other cryptocurrency networks, Uniswap is decentralized. In fact, Uniswap is one of the largest decentralized finance platforms (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 (AMM) 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 (or LP) for a Uniswap liquidity pool. To do so, all they have to do is purchase liquidity-pool tokens.

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.

How does an automated liquidity pool work?

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.

What Is the Uniswap Token (UNI)?

Uniswap has its own form of cryptocurrency, called the UNI. As of Nov. 18, 2021, it was the 18th most-held cryptocurrency, according to CoinMarketCap, with a market cap of $12.8 billion. By contrast, the largest cryptocurrency, Bitcoin, had a market cap of nearly $1.1 trillion, and Ethereum, the second-largest, had a market cap of over $480 billion.

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 627.8 million tokens in circulation, according to CoinMarketCap, as of Nov. 18, 2021.

UNI Price

As of Nov. 18, 2021, UNI is the 18th largest cryptocurrency by market cap, with a price of $20.39 per coin, an increase of over 500% year-over-year.

Like most forms of crypto, the UNI price is highly volatile. It reached a peak in May 2021 of just over $43.

What Can You Use Uniswap Coin For?

There are a few main ways to use the Uniswap token:

•   It can be used to speculate for profits, when traders try to buy low and sell back higher at a later date.

•   It can be used to decide how the Uniswap platform develops. UNI is a governance token, which is one of the only cryptocurrency types that gives users a say in platform decisions.

Who Uses Uniswap?

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.

Speculators also 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

Should You Invest in Uniswap Token?

Altcoins are generally considered to be speculative investments that carry high risk. In fact, there are few other investments available to the average person that carry greater risk and volatility.

If an investor has done all the research necessary to understand investing in crypto basics, what the Uniswap token is, how it works, and what it was designed for, then those with the necessary capital and risk tolerance may decide to take a chance on UNI. It’s common investment advice to never risk more than you can afford to lose.

Recommended: 6 Things to Know Before Investing in Crypto

How to Buy UNI Cryptocurrency

Buying UNI is similar to buying most other cryptocurrencies. Here are the basic steps.

1.    Get an exchange account. Users will have to follow all crypto regulations when doing so, which involves providing identifying information for know-your-customer and anti-money laundering rules. Make sure the exchange provides trading for the Uniswap token. UNI trades on many popular exchanges like Binance, Huobi Global, and Gate.io.

2.    Deposit money. After creating an account, a user can then deposit either some bitcoin, dollars (or other local fiat currency), or a stablecoin, depending on what trading pairs the exchange currently trades. Buying crypto directly with a credit card might also be an option, but doing so often involves higher fees (beyond fees charged by the exchange, credit cards often treat crypto purchases as a cash advance, with related additional fees).

3.    Buy UNI. Select the trading pair that includes UNI and the currency deposited during step number two. For example, if a user had Bitcoin and wanted to buy UNI, they would select the pair called “BTC/UNI.” If they had dollars, it might be “USD/UNI.” For a stablecoin like USDC, it might be “USDC/UNI.” Enter a buy order for the desired amount of coins at a desired price. Alternatively, on exchanges that include order books in the user interface (like Binance), simply select the first sell order and buy from it.

After buying their desired amount of Uniswap token, some users may want to consider moving their crypto off of an exchange and into a hardware wallet that supports UNI. This method of crypto storage provides extra security, as the coins can be taken offline and put into cold storage where hackers can’t access them.

Recommended: Cold Wallet vs. Hot Wallet: Choose the Right Crypto Storage

Note: selling UNI or any other crypto could result in a taxable event, meaning users might owe crypto taxes. There are a number of software solutions on the market that make it easier for users to track their transactions and calculate their capital gains or losses.

The Takeaway

Although most cryptocurrencies are traded on centralized exchanges, Uniswap — a protocol built on the Ethereum blockchain in 2018 — is a fully decentralized exchange (DEX). Uniswap allows users to trade cryptocurrency directly with one another without intermediaries, using an automated liquidity protocol that helps facilitate faster and more efficient trades.

The UNI token is currently the 18th most popular form of crypto, by market cap, according to CoinMarketCap. You can trade UNI on a centralized exchange or a DEX. Depending on the amount of UNI you have, you can participate in Uniswap’s governance.

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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