Centralized crypto exchanges are an integral part of the cryptocurrency market. Due to its capacity to trade high volumes with great settlement times and high liquidity, centralized exchanges have been the go-to platforms of many crypto players. That being said, there is now an inverse option of just that gaining massive momentum nowadays. Enter Decentralized exchanges (DEX), wherein no custodians or third-party is required to pull off efficient trading. In the direct opposite of the centralized exchanges, DEX is built on the foundation of trustless protocols. And with the topic of DEXs, there are no other terms that are seemingly associated with it more than Uniswap and Automated Market Makers (AMMs).
So, what are they? What are their roles in the crypto industry? How do they work? Are there any risks of using them? Let us answer all that and more below. Read on as we define Uniswap and AMMs as best as we can.
What is it?
Uniswap is a prominent decentralized exchange (DEX) protocol built within the Ethereum blockchain. Uniswap has established its place in the complex world of decentralization and within the crypto space today, largely thanks to its amazing features.
Unlike most exchanges today, which is specifically designed to take profitable fees, Uniswap as itself was designed for the good of everyone. It is basically a tool the community can utilize freely in order to trade token assets without the hassle of any middlemen or platform fees. Furthermore, Uniswap does not match buyers and sellers just to identify prices and finalize trades – which are a norm to the centralized exchanges. Instead, it uses a simple yet useful mathematic equation and token pools to do exactly that. All in all, Uniswap has proven itself as a highly beneficial platform for both organizations and individuals that are aiming to introduce a token of their own. Anyone can list ERC20 tokens to Uniswap platform easily.
How does it work?
As we have briefly discussed above, Uniswap derives crypto asset prices much different from other exchanges, especially centralized exchanges. In centralized exchanges, the price of a particular crypto is determined by the orderbook. The price is set according to the highest and lowest price possible at which traders would still be willing to buy or sell their assets. Uniswap, however, relies only on highly efficient exchange smart contracts called AMM.
All Ethereum tokens, as well as ERC-20 comparable tokens, are securely kept in the contracts. Whenever a user decides to swap the tokens for other pairs, their assets will be sent to the contract pool, and from there, they’d be sent to the said user. With that said, within Uniswap, users do not have to worry about their asset prices equaling the seller’s appointed prices. On top of that, there would always be an available crypto asset in the platform; users do not have to wait for anyone to spark an interest in selling.
In centralized exchange, you must surrender the custody of your funds before you can initiate trades. In Uniswap, you have total control of your funds. The token remains in your own wallet until the trade is executed by the smart contract. The receiving token arrives on your wallet simultaneously.
Another noteworthy feature of Uniswap is its expert inclusion of oracles. We all know that it is highly crucial for the success of a decentralized exchange to have a steady supply of external data. If it isn’t apparent yet, DEXs cannot be solely dependent on centralized sources to provide them external information – it is counterintuitive and ineffective. With the help of oracles, Uniswap has dependent sources for pricing data. It is also resistant to any forms of manipulations and tampering.
What are its risks?
On top of learning Uniswap’s great benefits and attractive features, one must also be made aware of its inherent risks. Because of its decentralized nature, anyone can list tokens, and there are many illegitimate projects that are purposely aiming to replicate the genuine projects. Traders should always double-check the contract address before executing any transactions. Notably, phishing risks and current outrageous gas fees also belong to the downsides of Uniswap.
What is an AMM (Automated Market Maker)?
Automated Market Makers, most commonly referred to as AMMs, are a specific function of the newer decentralized exchanges such as Uniswap and others. AMM utilizes complex mathematical operations to accurately set a price for a particular token. Just like normal DEXs, they too, have different trading pairs, such as Ether-USDT. However, what separates AMM from the typical DEX is that AMMs have no buy-or-sell orders. Instead of the order books, AMM uses a liquidity pool. The liquidity pool is a pool of tokens committed by the community members. The tokens from the pools are actually used by the AMM algorism to match the swapping transactions. The liquidity pool allows AMM to provide instant trade possible. In AMMs, smart contracts serve as the maker in a given exchange transaction.
The transaction fees collected by the traders are distributed to liquid providers. Anyone can participate in the liquidity pool to generate income. Anyone with an ERC20 wallet address can simply connect to the wallet to Uniswap liquidity pools (via common web browser) to providing liquidity. All processing fees are proportionally shared among liquidity providers automatically.
How do smart contracts contribute to the trading automation of AMMs?
Users interact with the liquidity pools whenever they trade on AMMs. Because of that, whenever the user wants the smart contract to execute a particular trade, the smart contract would promptly send their tokens to the liquidity pool. After that, a mathematical equation would then be performed to decide how many tokens from the other side of the trading pair users would receive in return. Basically, you commit a specific asset that will go to the pool, and then a mathematical formula will decide how much you will get back for it with an entirely different asset – as based on the trading pair.
The simplest and most practical formula used in determining returns is A multiplied by B equals C, wherein the A and B are represented by the amount of each token found in the pool, and C is a given constant. This particular equation is what defines the term “hyperbola.”
It is also worth noting that each trade will have its own amount of slippage – how much the size of the order moves the final price at which the token was sold or bought. The hyperbola shape, conversely, means that the slippage will be much lower with small orders, but ultimately larger, with more significant orders. Notably, Uniswap is also known for using this same formula.
What makes AMMs appealing nowadays?
AMMs solves the liquidity problems of DEXs plagued for years– which is arguably its biggest obstacle towards widespread adoption. AMMs do this because, unlike the traditional exchanges, there are no mangers or moderators. As already discussed above, AMM protocols are entirely permissionless and do not bound their users with the controversial and strict Know-Your-Customer (KYC) checks. All you need on AMMs is your wallet address.
AMM offers no listing fees or admission criteria. Anyone could quickly establish a liquidity pool on the platform for any given token.
In summary, user experience on AMMs is much more straightforward compared to its contemporaries. Its interfaces are very user-friendly, its operations are more streamlined, and most of all, it does not neglect the lingering issues that have been the bane of traditional platform users for quite a long time now.
What are its risks?
Despite its overwhelmingly positive reception and qualities, AMMs still has its own set of risks and limitations. Notably, hacks and vulnerabilities have already marked exchanges such as Balancer and Uniswap, wherein some liquidity providers have already lost money via hacks and other complex smart contract exploits. Furthermore, AMM traders are more than likely leaving their transaction trail exposed on ETH-explorer.
It is also, best to remember that AMMs cannot fully exist without depending on the conventional order book exchanges for arbitrage. On top of that, despite the helpful and truly innovative mathematical formulas that it uses, it still cannot genuinely represent the market itself.