Centralized exchanges, such as Binance and Coinbase, are where the majority of crypto trading takes place. A single authority governs these platforms, which is the company running the exchange, and users are required to place their funds under their control. They facilitate trading by using the traditional order book system. This form of trading is where buy and sell orders are highlighted in a long list, along with the total amount involved in every order. Market depth is the term used to refer to the amount of open buy and sell orders of an asset. A successful trade can be made through this system when a buy order is matched with a sell order on the same price and amount of an asset on the opposite side of the order book.
For instance, if you want to use a centralized exchange to sell 1 BTC at a price of $50,000, you have to wait for a buyer who is interested in buying an equal or higher amount of the same at that price on the other side of the order book. Liquidity is the primary issue with this type of system, referring to the number and depth of orders on the order book. Low liquidity means that people may not be able to fulfill their buy and sell orders.
What is Uniswap?
Unlike centralized exchanges, Uniswap is completely decentralized, which means that it is not owned and operated by one entity. It also uses a relatively new kind of trading model, which is known as an automated liquidity protocol. Developed in 2018, Uniswap operates on the Ethereum blockchain, which is the second-largest crypto project by market cap. This makes it compatible with all the ERC-20 tokens and infrastructure, like wallet services such as MyEtherWallet and MetaMask.
In addition, Uniswap is fully open-source, which means that its code can be copied by anyone for making its own decentralized exchange. Users can even list their tokens on the exchange free of cost. In contrast, normal exchanges charge high fees for listing new coins because they are profit-driven. Since it is a decentralized exchange (DEX), Uniswap also allows users to maintain complete control over their funds as compared to a centralized exchange where traders are required to give up control of their private keys for logging orders on an internal database, which can be more expensive and time-consuming.
When you retain control of your private keys on Uniswap, it reduces the risk of losing assets if the exchange gets hacked.
How does Uniswap Work?
Two smart contracts can be found on Uniswap; a ‘Factory’ contract and an ‘Exchange’ contract. These are automatic computer programs that have been developed for performing specific functions when certain conditions are fulfilled. In the case of Uniswap, new tokens are added to the exchange via the factory contract whereas the exchange contract is used for facilitating all ‘trades’ or token swaps. The updated Uniswap platform can be used for swapping any ERC-20 based token with another.
Automated Liquidity Protocol
The liquidity problem with centralized exchanges mentioned earlier is solved by Uniswap through an automated liquidity protocol. This essentially gives incentives to those trading on the exchange to become liquidity providers (LPs). The users of the platform pool in their money for creating a fund that’s used for executing all the trades that occur on the platform. There is a separate pool for every token that’s listed and every user can contribute to it. A math algorithm is used for working out the prices of every token.
In this system, a buyer and seller doesn’t have to wait for the opposite party to make an appearance in order to make a trade. Instead, any trade can be executed instantly at a price, provided that the pool has enough liquidity to facilitate it. Every liquidity provider is given a token in exchange for investing their funds, which represents their staked contribution made to the pool. For instance, if your contribution to a $100,000 liquidity pool is $10,000, then you would be given a 10% token of that pool.
You can redeem this token for a portion of the trading fees. A flat 0.30% fee is charged by Uniswap for every trade that occurs on the platform and it is automatically sent to a liquidity reserve. If a liquidity provider wants to exit, they are given a portion of the total fee, depending on the staked amount in that pool. The token they had received earlier for making the contribution is then destroyed. After the upgrade made to Uniswap, there was a new protocol fee added that could be turned on and off through a community vote, which puts 0.05% of the trading fee in a Uniswap fund for financing future development.
How to Use Uniswap
It is relatively straightforward for anyone to get started with Uniswap, but you just need to ensure that you have a wallet setup that supports ERC-20 tokens, such as WalletConnect, MetaMask, Formatic, Portis or Coinbase wallet. If you already have one of these wallets or have opened one, you need to add ether to it for trading on Uniswap and to pay for gas, which refers to the Ethereum transaction fees. The price of the gas payments can vary, as it depends on the number of people who are using the network.
If you take a look, you will discover that most of the wallets compatible with ERC-20 tokens give you three choices when you have to make a payment over the Ethereum blockchain; you can choose from slow, medium or fast. Obviously, slow is the cheapest and fast is the most costly, while medium falls somewhere between the two. This will determine the speed with which the Ethereum network miners process your transaction.
Uniswap also has a governance token known as UNI, which provides holders with the right to vote on changes and new developments made to the platform. This includes how minted tokens are distributed to the developers and the community, along with changes made to fee structures.