It’s that season again of tremendous pump and dump of the price of cryptocurrencies. The season where only the fastest fingers survive the challenge. This time, it takes the name of DeFi (Decentralized Finance) Yield Farming. and while a few speculators might have been fortunate enough to jump in and out of the bubble with over 10x in profits, others might already be far locked into the most recent crypto staking innovation a.k.a digital farming. (Whoever said farming wouldn’t be possible on the blockchain!)
One of the biggest decentralized trading protocol to have been used to unveil this farming innovation is the Uniswap Automated Market Maker.
While many hurriedly gambled with the innovation and got burnt, we have thought it wise to explain what Uniswap is, how the platform works and how to successfully participate in the liquidity pools using Uniswap.
What is Uniswap and How Does it Work?
Uniswap is an open-source automated liquidity protocol on Ethereum that allows for easy trading and listing of ERC20 tokens. It is built around the values of decentralization, censorship-resistance, security, and permissionless utility, Uniswap has become Ethereum’s most popular automated market maker (AMM) exchange since Uniswap’s V1 launch in November 2018.
The system simply powers the decentralized marketplace where all trading asset pairs are composed of reserves of two tokens which are equivalent on a 1:1 basis and all pairs are separately managed by their own smart contract.
As opposed to the order book DEXs and CEXs, the system affords just about anyone to become Liquidity Providers (LPs) for any given trading pair and this is done automatically when you trade or in other words, provide reserves for that pair on the Uniswap exchange.
The idea is that all LPs are given some form of shares for their services (trading activities) and these shares are redeemable should they decide to exit the liquidity pools.
The new system offers a range of key optimizations, including ERC20/ERC20 token pairs, price oracles, flash swaps, and more. At the time of this post’s writing, Uniswap V2 was facilitating nearly $200 million dollars’ worth of total liquidity and over $60 million in 24-hour volume. Moreover, the protocol’s builders are already in the process of preparing Uniswap V3.
Automated Market Makers and Order Book DEXs
On the Ethereum network, there are two major kinds of decentralized exchanges: order booked-based DEXs and AMM-based DEXs.
Order book DEXes rely on buy and sell orders around a given token. Buy orders are called bids, and sell orders are called asks. To this end, these exchanges list bid orders and ask orders across every price point, with the “top of the book” marking whatever the lowest ask and the highest bid prices are at a particular time. The cons of order-book marketplaces, though, is that they don’t work well for illiquid markets, and they can be particularly prone to market manipulation and front-running. Some examples of this kind of DEX include 0x, IDEX, and Ethfinex.
On the flip side, AMM-based DEXes like Uniswap rely on what’s called “algorithmic agents,” or “money robots,” rather than order books. Key to this DEX model is liquidity pools, in which users supply assets that a finely-tuned algorithm uses to make markets. Every AMM has its own customized algorithm with its own pros and cons. Ultimately, the algorithm’s unique formula is used to determine prices for users rather than a list of bid orders and ask orders.
How Uniswap Pools Work
Liquidity pools, like Uniswap, is now renowned for, are a cryptonative utility and a cryptonative earning opportunity.
Simply speaking, Uniswap’s liquidity pools are composed of pools of tokens, with each pool being secured by its own dedicated smart contract. With Ethereum as the foundational infrastructure, users can trade through these pools permissionlessly, anytime any day, and without account creation requirements.
The incentive for LPs to provide liquidity is the ability to earn a cut of a given Uniswap pool’s fees, as powered by their provided liquidity. For more on precisely how these pools work, check out defiprime’s longer guide on the subject here.
Even though the platform appears very much to have passed numerous product validation, one of which is a simple design, it doesn’t literally mean that the platform is totally free from risks.
One primary risk is that for smart contracts, the token contract is a central point. The central point in any system is also the most lucrative attack point. Any problem with the central point affects all users because all tokens/records are kept by it and everyone has to interact with it.
The Surge in Gas Fee Per transaction on Uniswap
Every Ethereum transaction needs a payment of ether (ETH), called “gas” or a “gas payment,” to be completed. Ethereum gas prices fluctuate daily in line with demand. If many folks are trying to use Ethereum all at once, then gas prices will be higher. If activity is low, then gas prices will be lower. Your Uniswap transaction cost is the sum in ETH it takes to process your trade or liquidity provision/removal. For up to date stats on current Ethereum gas prices, check out ethgasstation.info or etherscan.io/chart/gasprice.