Uniswap (UNI) and Automated Market Making: A Comprehensive Primer

Decentralized
exchanges
(DEXs),
such
as
Uniswap
(UNI),
serve
as
critical
components
within
the
crypto-financial
system.
These
platforms
enable
users
to
trade
cryptocurrencies
directly
with
each
other
or
through
liquidity
pools,
effectively
eliminating
the
need
for
a
counterparty
or
centralized
entity
to
execute
trades,
according
to

Glassnode
Insights.

Permissionless
Trading

Uniswap
stands
as
the
largest
DEX
protocol,
renowned
for
its
permissionless
access
and
user-friendly
interface.
Users
maintain
control
over
their
funds
and
transact
via
liquidity
pools
containing
assets
from
both
sides
of
a
trading
pair.
Additionally,
anyone
can
create
or
participate
in
a
trading
pool
for
any
token
pair,
making
DEXes
attractive
for
trading
various
digital
assets.

The
main
trade-offs
with
DEXs
revolve
around
the





scalability
of
the
underlying
blockchain,
leading
to
higher
latency
and
transaction
fees.
In
contrast,
centralized
exchanges
offer
faster
trade
execution
without
blockchain
transaction
fees,
though
users
must
transfer
assets
into
the
custody
of
the
exchange
operators.

Decentralized
Market
Making

Uniswap
introduced
a
pivotal
innovation
with
the
Automated
Market
Maker
(AMM)
design.
This
setup
facilitates
the
creation
of
liquidity
pools
and
adjusts
token
prices
based
on
the
relative
liquidity
balance
on
both
sides
of
a
trade.
In
traditional
exchanges,
Market
Makers
provide
liquidity
by
placing
buy
and
sell
orders
to
create
deeper
order
books.
Conversely,
DEXes
use
smart
contracts
to
replace
this
order
book
model
with
liquidity
pools,
with
prices
dictated
by
the
AMM
design.

Each
pool
contains
reserves
for
a
given
token
pair.
For
example,
the
WETH-USDC
pool
contains
reserves
of
both
WETH
and
USDC,
often
deposited
in
a
50:50
split
based
on
each
side’s
price.
The
AMM
design
allows
anyone
to
become
a
market
maker
by
depositing
tokens
into
the
pool.
In
return,
Liquidity
Providers
(LPs)
receive
fees
from
trades
in
the
pool,
typically
a
small
percentage
of
the
transaction
value,
distributed
proportionally
based
on
their
pool
share.

Price
Determination
via
the
Constant
Product
Formula

Liquidity
pools
utilize
AMM
algorithms
to
manage
token
prices
and
balance
liquidity
within
the
pool
post-trade.
Whenever
a
trade
occurs,
the
algorithm
adjusts
the
token
quantities
in
the
pool
and
recalculates
each
token’s
price
based
on
the
remaining
quantities
using
the
Constant
Product
Formula:

x
*
y
=
k

• x
  is
  the
  quantity
  of
  token
  in
  liquidity
  pool
  a
• y
  is
  the
  quantity
  of
  token
  in
  liquidity
  pool
  b
• k
  is
  a
  constant

The
product
of
the
two
token
quantities
remains
constant
after
a
trade.
If
someone
buys
Token
B
using
Token
A,
the
sold
amount
of
Token
A
is
added,
and
the
purchased
amount
of
Token
B
is
removed
from
the
pool.
This
process
keeps
the
product,
k,
constant
as
the
token
quantities
change
with
each
trade.
The
exchange
rate
is
determined
by
the
ratio
of
the
change
in
x
to
the
change
in
y.

Additionally,
arbitrage
opportunities
help
maintain
token
prices
in
alignment
with
other
trading
venues.
Should
a
DEX
liquidity
pool
offer
a
token
at
a
steep
discount
compared
to
centralized
exchanges,
traders
can
buy
it
via
the
DEX
and
sell
it
at
the
exchange
to
capture
the
spread.

Concentrated
Liquidity

Earlier
AMMs
typically
used
a
50:50
asset
split
with
liquidity
distributed
across
the
full
range
of
possible
prices
for
each
token.
Uniswap
V3
introduced
the
concept
of
concentrated
liquidity,
allowing
liquidity
to
be
applied
within
a
designated
price
range.
These
ranges
are
defined
by
discrete
points
on
a
given
price
scale,
and
fees
are
earned
only
when
the
market
trades
within
this
range.

This
design
enhances
the
user
experience
for
DEX
traders
by
providing
tighter
spreads.
It
also
gives
Liquidity
Providers
more
opportunities
to
actively
manage
their
positions
and
improves
capital
efficiency
for
the
pools.
This
can
reveal
insights
into
market
makers’
price
and
volatility
expectations
as
they
adjust
their
liquidity
positions.

Fee
Tiers

Uniswap’s
fee
revenue
mechanism
attracts
liquidity
through
different
fee
tiers:
0.01%,
0.05%,
0.30%,
and
1.00%.
These
tiers
accommodate
varying
levels
of
risk
and
trading
volume.
The
lowest
fee
tier
(0.01%)
suits
pools
involving
stablecoins
or
assets
with
minimal
price
volatility,
encouraging
higher-volume,
lower-margin
trading.
Higher
fee
tiers
compensate
LPs
for
taking
on
asset
inventory
risk,
a
higher
likelihood
of
impermanent
loss,
and
lower
expected
trade
volumes.

Summary
and
Conclusions

Uniswap
has
pioneered
new
crypto-financial
primitives
like
the
AMM
protocol
and
enabled
permissionless
trading
via
blockchains.
These
DEX
protocols
align
incentives
so
market
makers
have
a
fee
revenue
incentive
to
provide
liquidity,
while
traders
access
global
trade
execution
without
relinquishing
custody
of
their
funds.

While
this
article
covers
many
key
design
elements
of
DEXs,
the
ecosystem
continues
to
push
the
boundaries
of
what
is
possible
in
a
decentralized
future.

Image
source:
Shutterstock

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