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Decentralized exchanges are a solution to various problems of centralized exchanges like the risk of hacking, mismanagement, and arbitrary fees. As such, decentralized exchanges also have their own problems as they lack liquidity. It is where Uniswap Exchange comes into the picture. 

Uniswap is a decentralized exchange that aims to solve the liquidity issues where the exchange is able to swap tokens without depending on the buyers and sellers who create that liquidity.  

Uniswap is one of Ethereum’s biggest wins right now and the project has a raft of new inventions coming up in the future. Let’s go in-depth about what is Uniswap, how does it work, how to use Uniswap, and much more. 

What is Uniswap?

Uniswap is a Decentralized Exchange hosted on the Ethereum Blockchain as well as a public, open-source front-end client. Uniswap exchange allows easy trading and listing of ERC20 tokens. 

This decentralized exchange is built around the values of decentralization, censorship-resistance, security, and permissionless utility. Hence, it has become Ethereum’s most popular Automated Market Maker (AMM) exchange after its launch in November 2018. 

Uniswap allows the users to contribute to liquidity pools for any ERC20 tokens and get a commission in the form of exchange fees for doing so. Uniswap exchange has two features which are Swap and Pool. 

The Swap feature of Uniswap allows users to swap Ethereum with different ERC-20 tokens. The Pool feature allows users to earn through providing liquidity, wherein the tokens are deposited into the smart contracts and the user will receive pool tokens in return. 

Let’s now understand what are these liquidity pools. 

What are the liquidity pools?

Liquidity pools are pools of tokens locked in a smart contract. They facilitate trading by providing liquidity and are used in some of the decentralized exchanges. Bancor was the first project to introduce liquidity pools, but Uniswap made them a trendsetter. 

How do they work? 

One liquidity pool holds a pair of tokens and each pool will create a new market. DAI/ETH can be a good example of a liquidity pool on the Uniswap exchange. When a pool is created, the first liquidity provider sets the initial price of assets in the pool. The liquidity provider will be rewarded with LP tokens for supplying an equal value of both tokens to the pool. 

When a trade is assisted by the pool, a 0.3% fee is distributed uniformly among the LP token holders. If any liquidity provider wants to get their liquidity back, then they should their LP tokens. Each token swap facilitated by a liquidity pool results in a price adjustment. This mechanism is called the Automated Market Maker (AMM) and different protocols use slightly different market maker algorithms. 

Some DEX like Uniswap uses a constant product market maker algorithm which ensures that the product of the quantities of the 2 supplied tokens always remains the same. So a pool can always provide liquidity irrespective of how large the trade is.