The burgeoning decentralized finance (DeFi) ecosystem aims to use decentralized, non-custodial financial products to replace centralized middlemen in financial applications such as loans, insurance and derivatives.

Uniswap is an example of one of the core products in the DeFi ecosystem, the decentralized crypto exchange, or DEX. DEXs aim to solve many of the problems of their centralized counterparts, including the risk of hacking, mismanagement, and arbitrary fees. However, decentralized exchanges have their own problems, mainly lack of liquidity—which means a lack of amount of money sloshing around an exchange that makes trading faster and more efficient.

Uniswap is trying to solve decentralized exchanges' liquidity problem, by allowing the exchange to swap tokens without relying on buyers and sellers creating that liquidity.

Below we explore how Uniswap works—and how it became one of the leading decentralized exchanges built on Ethereum.

What is Uniswap?

Uniswap is a protocol on Ethereum for swapping ERC20 tokens. Unlike most exchanges, which are designed to take fees, Uniswap is designed to function as a public good—a tool for the community to trade tokens without platform fees or middlemen. Also unlike most exchanges, which match buyers and sellers to determine prices and execute trades, Uniswap uses a simple math equation and pools of tokens and ETH to do the same job.

What’s so special about Uniswap?

Uniswap’s main distinction from other decentralized exchanges is the use of a pricing mechanism called the “Constant Product Market Maker Model.”

Any token can be added to Uniswap by funding it with an equivalent value of ETH and the ERC20 token being traded. For example, if you wanted to make an exchange for an altcoin called Durian Token, you would launch a new Uniswap smart contract for Durian Token and create a liquidity pool with–for example–$10 worth of Durian Token and $10 worth of ETH.

Where Uniswap differs is that instead of connecting buyers and sellers to determine the price of Durian Token, Uniswap uses a constant equation: x * y = k.

In the equation, x and y represent the quantity of ETH and ERC20 tokens available in a liquidity pool and k is a constant value. This equation uses the balance between the ETH and ERC20 tokens–and supply and demand–to determine the price of a particular token. Whenever someone buys Durian Token with ETH, the supply of Durian Token decreases while the supply of ETH increases–the price of Durian Token goes up.

As a result, the price of tokens on Uniswap can only change if trades occur. Essentially what Uniswap is doing is balancing out the value of tokens, and the swapping of them based on how much people want to buy and sell them.

What else is different about Uniswap?

Absolutely any ERC20 token can be listed on Uniswap–no permission required. Each token has its own smart contract and liquidity pool–if one doesn’t exist, it can be created easily.

Once a token has its own exchange smart contract and liquidity pool, anyone can trade the token or contribute to the liquidity pool while earning a liquidity provider fee of 0.3%. To contribute to a liquidity pool, you need an equal value of ETH and ERC20 tokens.

How are Uniswap tokens produced?

Whenever new ETH/ERC20 tokens are contributed to a Uniswap liquidity pool, the contributor receives a “pool token”, which is also an ERC20 token.

Pool tokens are created whenever funds are deposited into the pool and as an ERC20 token, pool tokens can be freely exchanged, moved, and used in other dapps. When funds are reclaimed, the pool tokens are burned or destroyed. Each pool token represents a user’s share of the pool’s total assets and share of the pool’s 0.3% trading fee.

How to make your first trade on Uniswap

Through Uniswap, you’re able to purchase ether (ETH) and any of the thousands of ERC20 tokens supported by the platform.

To do this, you’re going to need some ETH in your balance to pay for any transaction fees, as well as something to trade for the ERC20 token you want. This might be ETH, or another ERC20 token. For example, if you’re looking to trade USD Coin (USDC) for UNI, you’re going to need to hold USDC in your wallet plus some ether to cover the transaction fee.

Here, we’ll cover how to make your first trade on Uniswap—by purchasing some UNI tokens with ETH.

Step 1: First head over to the Uniswap exchange platform.

On the top right, click the ‘Connect to a wallet’ button, and log in with the wallet you wish to trade with. This can be either a MetaMask, WalletConnect, Coinbase Wallet, Fortmatic, or Portis Wallet.

For the purposes of this tutorial, we’ll log in with a MetaMask wallet.

Step 2: Once logged in, the trading interface will appear.

In the top field, select the token you wish to exchange for the token you want. We’ll select ETH. In the bottom field, search for the token you wish to purchase, or select it from the drop-down menu, in this case UNI.

Step 3: Now you’re ready to set up your order. You can either choose how much you want to spend by entering a number in the top field, or choose how much to buy by entering a number in the bottom one.

In our example, we’ll buy 0.1 ETH worth of UNI tokens.

Step 4: At the bottom of the order menu, you’ll then see how much you can expect to receive.

If you’re happy with these figures, click the ‘Swap’ button.

Your wallet click will then prompt you to confirm the trade, and potentially adjust the fees to a number that works best for you.

When you’re ready, confirm the transaction and it will then be processed. Once it’s done, your tokens will appear in your ERC20 wallet.

Next steps

Once you've completed your first trade on Uniswap, there are plenty of options for more advanced users.

Since Uniswap is an open protocol of smart contracts, a number of different front-end user interfaces have already been created for it. For example, InstaDApp allows you to add funds into Uniswap pools without needing to access the official Uniswap user interface.

Interfaces such as Zapper.fi allow users to add funds to Uniswap pools using just ETH instead of ETH and another token. The interface even offers simple one-click solutions for purchasing pool tokens in combination with bZx token strategies.

With an array of official and unoffical resources for developers to build on the protocol, we should expect to see many more integrations between Uniswap’s unique token swapping system and new decentralized finance (DeFi) products in the coming years.

Uniswap V2 and V3

Though Uniswap launched back in November 2018, it wasn't until relatively recently that the protocol began to see significant traction.

The release of Uniswap V2 in May 2020 saw a major upgrade that allows for direct ERC20 to ERC20 swaps, cutting Wrapped Ether (WETH) out of the equation where possible. Uniswap V2 also added support for incompatible ERC20 tokens like OmiseGo (OMG) and Tether (USDT), and added a host of technical improvements that make it more desirable to use.

As liquidity mining and yield farming platforms dramatically increased in popularity in 2020, Uniswap saw a corresponding surge in interest, since many DeFi platforms allow Uniswap liquidity providers to see an additional return on their LP tokens.

This, in combination with the 0.3% exchange fees distributed to liquidity providers—and the platform’s popularity as a launchpad for popular DeFi project tokens—has seen Uniswap rise the ranks to become one of the leading DeFi platforms by total value locked (TVL)—a measure of the total value of crypto assets locked up in the platform.

In May 2021, Uniswap V3 launched, with the latest iteration of the DEX adding a number of new features. First up is concentrated liquidity, which enables liquidity providers to allocate liquidity within a custom price range. That, in turn, means that traders don't have to put as much capital on the line to achieve results.

V3 also adds more fee tiers, enabling traders to better determine their risk level when trading volatile assets (which can change in price between when a trade's initiated and executed). It also adds "easier and cheaper" oracles, which ensures that the DEX's price data is up to date.

Finally (and perhaps least essentially) it also generates non-fungible tokens (NFTs) based on LP positions, turning them into "on-chain generated art".

UNI token launch and airdrop

In September 2020, Uniswap launched UNI, the network’s governance token, airdropping 400 UNI tokens to every wallet address that had interacted with the Uniswap protocol before September 1.

From a distribution of 150 million UNI tokens, around 66 million were claimed in the first 24 hours following the airdrop. After distributing 40% of the tokens in the first year, it will taper down by 10 percentage points in each subsequent year, until all the tokens have been allocated.

Uniswap plans to distribute a capped total of 1 billion UNI over four years, with 60% earmarked for distribution to the community, 21.5% allocated to Uniswap employees, and the remaining 18.5% going to investors and advisors.

As a governance token, UNI entitles holders to a vote in how the protocol is run, affording them immediate ownership of Uniswap governance, the UNI community treasury, the protocol fee switch, eth ENS, the Uniswap Default List (tokens.uniswap.eth) and SOCKS liquidity tokens. The token was quickly listed on the Coinbase Pro exchange, and soon after on the main Coinbase exchange.

Uniswap’s token launch can be considered a response to the rise of SushiSwap, a clone of the protocol that added a token to encourage usage. In a more direct challenge, SushiSwap also tried to drain Uniswap of liquidity through a process called “vampire mining”.

Recent developments

In less than a year, Uniswap V2 has propelled the platform to meteoric growth.

In February 2021, it became the first decentralized exchange to process more than $100 billion in trading volume, and now frequently exceeds $1 billion in trading volume each day. This performance has seen it become not only the largest DEX by trading volume, but one of the top five most popular exchanges period.

Meanwhile, the Uniswap governance token (UNI) has climbed to become the 10th largest cryptocurrency by market capitalization after reaching a peak value of over $44. This was at least partially driven by the growing popularity of yield farming pools, many of which require users to hold UNI or Uniswap LP tokens.

The platform also found itself at the center of the recent Unisocks (SOCKS) craze, a token backed by a physical pair of socks. Although the first pair sold for just $12, in February 2021, a unique sale format that uses a bonding curve to set the price saw one pair sell for a whopping $92,000.

But it hasn’t all been smooth sailing for Uniswap. As a result of massive congestion on the Ethereum network, transaction fees have shot through the roof—making trading on Uniswap an expensive task, particularly when concerning low-value trades.

This has seen the proliferation and growth of a huge range of alternative platforms, including TRON’s JustSwap, Qtum’s QiSwap, and Kyber Network—all of which promise faster transitions, lower fees, or both. Uniswap also saw its daily transaction volume briefly exceeded by PancakeSwap—a similar automated market maker (AMM) built on Binance Smart Chain.

But Uniswap's position as one of the leading DEXs has given it considerable clout. Some are looking to leverage that as the DeFi sector grows—and, inevitably, comes under the gaze of regulators. In May 2021, members of the Uniswap community launched a governance proposal to set up a "political defense" fund with a budget of 1-1.5 million UNI.

The aim of the fund is to preempt regulatory and tax threats using lawyers, lobbyists and organizers, enabling the nascent DeFi space to counter "massive spending from traditional finance players."

With the likes of the SEC and CFTC now considering the question of DeFi regulation, Uniswap may have a fight on its hands.