A 5-Minute Complete Guide to Uniswap Protocol

Uniswap Protocol is an automated liquidity protocol powered by a constant product formula and implemented in a system of non-upgradeable smart contracts on the Ethereum blockchain.

It obviates the need for trusted intermediaries, prioritizing decentralization, censorship resistance, and security.

Uniswap Protocol is open-source software licensed under the GPL. 

Uniswap Protocol sounds like a big deal; being able to exchange any ERC20 token, including the native ETH token, without middlemen, and allowing anyone with an Ethereum address to contribute to the exchange’s liquidity, and thus earn from it, is no small feat.

How Uniswap Protocol works?

Each uni swap smart contract, or pair, manages a liquidity pool made up of reserves of two ERC-20 tokens. 

• Pairs act as automated makers. One token is accepted to the other as long as the “constant product” formula is preserved. The formula is simple expressed as X*Y = k, which states that trades must not change the product (k) of a pair’s reserve balances (X and Y). Because k remains unchanged from the reference frame of a trade, it is often referred to as the invariant. This formula has the desirable property that larger trades (relative to reserves) execute at exponentially worse rates than smaller ones. 
• Uniswap Protocol applies a 0.30% fee to trades, which is added to reserves. As a result, each trade actually increases k. This functions as a payout to LPs (liquidity providers), which is realized when they burn their pool tokens to withdraw their portion of total reserves. In the future, this fee may be reduced to 0.25%, with the remaining 0.05% withheld as a protocol-wide charge. 

Because the relative price of the two pair assets can only be changed through trading, divergences between the Uniswap price and external prices create arbitrage opportunities.

This mechanism ensures that Uniswap prices always trend toward the market-clearing price. 

Features of Uniswap Protocol

• Uniswap is a public, open-source, non-profit project aimed to benefit the Ethereum ecosystem. The smart contracts of the project have been written in Solidity.
• It’s 100% on-chain. There are no dependencies required outside the Ethereum blockchain for it to operate. As a result, anyone can access Uniswap’s full capabilities using web3 and embed Uniswap functionalities within their apps as they please.
• Uniswap consists of 2 smart contracts, a “Factory” contract, and an “Exchange” contract.

Types of Users

The Uniswap ecosystem consists primarily of three types of users: liquidity providers, traders, and developers.

Liquidity providers are incentivized to contribute ERC-20 tokens to common liquidity pools.

Traders can swap these tokens for one another for a fixed 0.30% fee.

Developers can integrate directly with Uniswap smart contracts to power new and exciting interactions with tokens, trading interfaces, retail experiences, and more.

Liquidity providers

Professional LPs are focused on market making as their primary strategy.

They usually develop custom tools and ways of tracking their liquidity positions across different Defi projects.

This allows the tokens to be bought and sold more easily and unlocks interoperability with other Defi projects through Uniswap.

Some Defi pioneers are exploring complex liquidity provision interactions like incentivized liquidity, liquidity as collateral, and other experimental strategies.

Uniswap Protocol is the perfect protocol for projects to experiment with these kinds of ideas.

Traders

Speculators use a variety of community-built tools and products to swap tokens using liquidity pulled from the Uniswap protocol.

DAPP users buy tokens on Uniswap for use in other applications on Ethereum.

Smart contracts that execute trades on the protocol by implementing swap functionality (from products like DEX aggregators to custom Solidity scripts).

Developers

The open-source, accessible nature of Uniswap means there are countless UX experiments and front-ends built to offer access to Uniswap functionality.

Uniswap Protocol functions are found in most of the Defi projects. 

DEX (decentralized exchange) aggregators pull liquidity from many liquidity protocols to offer traders the best prices but splitting their trades.

Uniswap Protocol is the biggest single decentralized liquidity source for these projects. 

Smart contract developers use the suite of functions available to invent new Defi tools and other various experimental ideas. See projects like Unisocks or Zora, among many, many others.

Benefits of Uniswap Protocol

• Decentralized, not reliant on third parties. Anyone can connect to a Uniswap contract via web3 and create custom apps on top of them. 
• Ability to create an exchange for any ERC20 token.
• Whales will most likely not target Uniswap because of the market rate equation and limitations it entails.        
• Non-profit
• Cheap to trade compared to other decentralized exchanges. 

Drawbacks of Uniswap

• Relies on arbitrage trading to keep exchange rates in check, so there will always be a need for other forms of exchange to keep the Uniswap exchange rates balanced
• Gas prices are needed to be spent to perform swaps even more so for ERC20 to ERC20 token swaps. 
• Uniswap is still under development even though their documentation is not yet complete and is still experimental. 

Conclusion

With the above critiques in mind, it is a fair assumption that only time will tell how Uniswap will be used and how the protocol will evolve. 

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