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DeFi Decrypted: Uniswap and UNI

DeFi Decrypted: Uniswap and UNI

Explainers DeFi

12 Oct 2020

Uniswap is a protocol for the decentralized exchange of ERC20 tokens based on the Ethereum blockchain. The service runs on a set of smart contracts making it completely decentralized, censorship-resistant and permissionless.

Since the launch of its governance token UNI, the protocol has been on a wild ride. The total market cap of UNI places automated market maker Uniswap among the one of most valuable projects in DeFi. Let’s find out what Uniswap is all about and how they achieved to recapture DeFi buzz with the UNI airdrop.

How Uniswap works

Uniswap was created by Hayden Adams with the help of a grant issued by the Ethereum Foundation to fund development and auditing prior to launch. The first version of Uniswap was launched on the last day of the Devcon 4 conference, with only $30,000 worth of initial liquidity across 3 tokens. It quickly gained traction which opened up the way to an initial seed investment that enabled the team to work on improving the protocol and launching the second version.

The main feature that was added to Uniswap V2 were the ERC20/ERC20 liquidity pools. Rather than using the traditional order book model, Uniswap pools tokens into smart contracts and users trade against these liquidity pools. Anyone can swap tokens, add tokens to a pool to earn fees, or list a token on Uniswap.

Instead of using order books for price discovery, where the price of an asset is derived from the meeting point between the highest buy and lowest sell bid, Uniswap uses Exchange smart contracts to pool tokens and determine prices.

Say you’re trading ETH for DAI, the ETH is sent to the contract’s pool and DAI is sent to you. There is no need to wait for order book matching as you trade with smart contracts directly. The amount of DAI you get is based on an automated market maker formula - based on the ratio of ETH to DAI in the pool.

The pools maintain a ratio relative to the price of the rest of market through people arbitraging the pool. Say the pool is out of balance, and instead of the market rate of 100 DAI for 1 ETH, you can get 200 DAI for 1 ETH. Market makers wouldn’t hesitate for a second and put new ETH in the pool to draw out DAI and sell that on another exchange for profit. Before long, this trading activity rebalances the pool. It’s an extreme example, but it helps illustrate how liquidity pools retain market prices.

Anyone can add liquidity to pools. When liquidity providers add to an established pool, they should add a proportional amount of both tokens, otherwise the liquidity they added is at risk of being arbitraged. This logic helps pools grow in depth while maintaining price stability. Larger liquidity pools are beneficial as they allow for bigger swaps to occur without skewing the pool ration. Uniswap incentivizes users to add liquidity by rewarding providers with fees collected by the protocol.

Sushi with a fork

As DeFi captured more and more market share, trading volume on Uniswap started going through the roof. At some point, trading volume was over $500M, surpassing some of the biggest centralized exchanges like Kraken and Coinbase. In August 2020, SushiSwap came into play. The project is a fork of Uniswap and was created in direct competition.

In just a couple of days, SushiSwap exceeded more than $1 billion in total value locked in the protocol, draining liquidity from its parent UniSwap having already aggregated over 75% of its assets. In just 6 days, native token SUSHI gained 220% from $2.26 on 29 August to $7.24 on 3 September. But after the hype subsided, some of that liquidity returned to UniSwap and the protocol soon returned to levels that were still higher than before SushiSwap was even created.

And then UniSwap hit the markets with its own governance token: UNI.

Governance UNI token, putting the community in control

On September 16, Uniswap announced the launch of governance token UNI. What captured attention everywhere was the anyone who had used the service before the 1st of September was eligible for claiming 400 UNI as part of a massive airdrop. On top of that, the liquidity providers of the protocol were also retrospectively rewarded with extra UNI tokens. The UNI tokens were distributed to around 50,000 Ethereum addresses making them one of the most widely distributed tokens in the space.

On the day of the announcement, 400 UNI was worth around $1200. In just a couple of days, UNI was traded everywhere – both on decentralized exchanges in DeFi and centralized exchanges. The token’s value quickly rose to $8, meaning the gifted 400 UNI were worth around $3200.

The introduction of UNI as a governance token enables shared community ownership and a vibrant, diverse, and dedicated governance system, which is designed to actively guide the protocol towards the future. The Uniswap governance framework is limited to contributing to both protocol development and usage as well as development of the broader Uniswap ecosystem. In doing so, UNI aims to be fully publicly-owned and self-sustainable infrastructure while protecting its indestructible and autonomous qualities.

The community of UNI now holds significant power to shape the evolution of protocol. As the team stated on their own blog: “A community-managed treasury opens up a world of infinite possibilities. We hope to see a variety of experimentation, including ecosystem grants and public goods funding, both of which can foster additional UniSwap ecosystem growth. UniSwap has set the standard for automated liquidity provision: it is now time to set the benchmark for responsible but radical, long-term aligned on-chain governance systems.”

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