What is Uniswap Protocol? How Does a Uniswap Pool Work?

Uniswap is an exchange protocol that allows users to swap ERC20 tokens. Rather than using the traditional order book model, Uniswap pools tokens into smart contracts, and users trade against these liquidity pools. Anyone can exchange tokens; you can also add them to a pool to start earning fees or even list one on Uniswap.

Without getting too technical, a Uniswap liquidity pool is used to match buyers and sellers or derive asset prices. Looking into Uniswap and what it offers can prove to be a profitable move if you’re interested in cryptocurrency beyond trying to make a quick buck on Bitcoin slots.

And since you’re reading this article, you’re probably here because you’ve heard of Uniswap, and you’re wondering what it is and how it works. I’ll do my best to explain Uniswap in simple terms so you can see why it’s unique from other exchanges like Binance and what kinds of benefits it has over these traditional exchanges.

What is Uniswap?

Uniswap is an open, decentralized way of creating a “meta” exchange that lists all centralized exchanges as ‘markets.’ To make this easier to understand, think of the ‘market’ as an equivalent to a centralized exchange like Binance or Kucoin on top of Ethereum: buyer = user; seller = market (functionally equivalent); order book = order book; transactions = transactions; precisely what we’d expect from any regular centralized exchange.

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The only difference between a regular centralized exchange and markets is that the latter don’t have backend servers, nor do they interact with centralized exchanges. Instead, they operate as decentralized smart contracts on Ethereum.

Uniswap creates a standardized way of creating an exchange in layman’s terms and lets anyone create their own exchange as long as they follow that standard (and charge fees to cover server costs).

What’s more, Uniswap doesn’t store any user data in its backend – only in its network space (the nodes). All transactions occur off-chain, similar to how exchanges currently work today.

Glossary

Now that we’ve gone over the basics of the Uniswap protocol, you’ll need to brush up on some Uniswap-related vocabulary to make the best use of that knowledge. After reading this section, you’ll have a better understanding of liquidity pools, as well as how Uniswap is applied to connect buyers and sellers.

Liquidity pool

A liquidity pool is a finite number of tokens held by a smart contract. Anyone can join a liquidity pool, which will add tokens to the pool’s balance. Uniswap allows pool operators to charge fees based on their pool size.

Pool operators may also have a transaction fee set, which will be added to the base fee and paid to the person who submitted the order. This fee is totally optional, and it does not affect whether a person’s orders are processed. It is purely there for stakers’ convenience.

Uniswap

The protocol’s name itself. It is intended to help buyers and sellers exchange tokens without intermediaries, paving the way for decentralized exchanges to take over.

Order Book

Ordinarily, exchanges work by users putting in ‘buy’ or ‘sell’ orders on an order book. Orders are matched against each other, and the matching pairs are sent to the backend for execution. Uniswap works differently. Instead of using an order book, it operates on a list of liquidity pools with their corresponding order books, allowing users to swap their tokens against these pools.

Each liquidity pool has a creator, which maintains an “order book” with one bid and one ask price for each token. For example, if the liquidity pool has 100 OMGs, there would be an ask price for 100 OMGs at 0.01 ETH/OMG, and an ask price for 101 OMGs at 0.02 ETH/OMG. Users that want to trade on this liquidity pool can choose the price they want to change at.

However, this price must be at or below both the bid and ask prices. If the user is willing to sell at 0.008 ETH/OMG, they will need to match a current ask price at 0.008 ETH/OMG or lower. Alternatively, if they want to buy at 0.03 ETH/OMG, they will have to bid price at 0.03 ETH/OMG or higher.

The Bottom Line

Hopefully, this article has helped you understand the Uniswap protocol and Uniswap liquidity pools, as well as how they contribute to shaping the world of popular, decentralized cryptocurrency exchanges. You should consider using Uniswap if you want to trade without sky-high commissions and get the right value for your hard-earned (or hard-mined) cryptocurrency.

However, keep in mind that cryptocurrencies can be highly volatile assets. It is not the best option to store your savings. Remember only to invest the cash you can afford to lose and diversify your portfolio to minimize the risks. Good luck!

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