Uniswap

Introduction to Uniswap

Uniswap is an Ethereum-based protocol designed to facilitate the automated exchange of ETH and ERC20 token digital assets. Fully deployed on-chain, the protocol can be used by any individual user with a decentralized wallet (currently supported wallets include MetaMask, WalletConnect, Coinbase Wallet, Fortmatic, Portis). Uniswap can also be considered a DeFi project, as it seeks to use decentralized protocols to completely eliminate intermediaries in digital asset trading.

Uniswap contains two types of smart contracts:

1. Trading Contracts

2. Factory Contracts

These smart contracts are written in the Vyper programming language and are core components for the implementation of various Uniswap protocol functions. A trading contract supports a specific ERC20 token, and each trading contract holds a certain amount of ETH and the supported ERC20 token. This means that transactions executed in an ERC20 token-ETH trading contract are based on the relative supply of ETH and the ERC20 token in the contract.

Using ETH as an intermediary, a trading contract can also facilitate the direct exchange of one ERC20 token for another.

Factory Contracts can be used to deploy new trading contracts. Therefore, any ERC20 token that does not yet have a trading contract on Uniswap can use the factory contract to deploy one. Any Ethereum user can do this via the createExchange() function. The factory contract serves as a “registration center” for Uniswap trading contracts, allowing users to find all ERC20 tokens and trading addresses that have been added to the Uniswap system. Once a trading contract is deployed, the factory contract does not perform background checks on the ERC20 token in the contract. There is only the restriction that “each trading contract contains only one ERC20 token.” Therefore, users should only engage in trading with ERC20 tokens from projects they trust.

Asset Liquidity on Uniswap

The design structure of the Uniswap protocol differs entirely from the trading model of traditional digital asset exchanges. Most traditional exchanges use an “order book” to match buyers and sellers of a digital asset. Uniswap, on the other hand, uses reserve liquidity to facilitate digital asset exchanges within the protocol.

The reserves in a trading contract are provided by numerous “liquidity providers” who deposit equal values of ETH and ERC20 tokens into the contract. The first liquidity provider to contribute liquidity has the right to set the exchange rate between the ERC20 token and ETH. If the exchange rate set by the first liquidity provider differs from the larger market, arbitrage traders will move the price to align with the larger market rate. After that, all liquidity providers will base their calculations on the exchange rate when they first provided liquidity.

Uniswap also issues a “liquidity token” that conforms to the ERC20 standard. This liquidity token represents a liquidity provider’s contribution to the trading contract. Uniswap imposes the restriction that “a trading contract supports only one ERC20 token” in order to encourage liquidity providers to concentrate their liquidity in a single trading contract’s reserve. The liquidity token tracks each liquidity provider’s share of the total reserve. Liquidity providers can choose to destroy their liquidity tokens at any time and redeem the corresponding share of ETH and the ERC20 token from the trading contract.

Liquidity providers can also choose to sell or transfer their liquidity tokens directly without removing liquidity from the contract. However, Uniswap liquidity tokens are strictly limited to a specific trading contract, and there is no separate native digital asset associated with the Uniswap protocol. Liquidity providers add liquidity by calling the addLiquidity() function, and in return, they receive a share of the trading fees generated by transactions.