Let’s say there is a town with a simple, but a thriving economy. This economy requires the exchange of two raw materials: lumber (wood) and iron. Its demand and supply constantly change because they are traded directly against each other. This sometimes can cause difficulties.
One week, the townspeople have plenty of lumber but were short on iron. The following week, all the lumber was gone and the community was left with nothing but iron. There always seems to be a liquidity problem with these materials.
The idea behind Uniswap
Annoyed by the circumstances, the elders of the town decided to put their heads together and came up with a solution.
Whenever there was an abundance of one of the materials, the surplus was stored away. After a few months, they had a decent pool of both materials available. If that wasn’t enough, the ratio between these two materials (in terms of quantity) made it possible to determine a fair exchange ratio. JACKPOT!
How exactly does Uniswap work?
Whenever someone has a surplus of lumber but needs iron, they approach the local market (a liquidity pool) and swap the two materials in the proper ratios. They will have to pay a small fee to keep the warehouse running. Maybe about 0.3% of the total value of the material he is offering.
But wait, doesn’t that change the ratio between the stored materials?
It sure does! It also changes the price, this is intentional because the lumber has just become a bit less valuable than iron. Supply and demand dictate the price in a free market. Naturally, this also works the other way round.
So what do I get out of this, storing all my extra iron in a big warehouse?
For storing your materials, you get rewarded in fees proportional to the amount of material you provided.
Is this really how Uniswap works?
No, but it is pretty close. When you provide liquidity to Uniswap, you have to provide the assets in pairs at the current ratio between those assets.
For example, if you want to provide ETH to the ETH/USDT pool, you have to provide an equal amount of ETH and USDT to the pool. You do that by transforming those two coins into a special liquidity pool token. This token will be called something like UNI-V2 ETH-USDT. It is used to determine your share of the pool and your share of the fees collected.
Why do people swap their coins via Uniswap?
People have used and trusted Centralized-Exchanges (CEX) for quite some time and it worked just fine. You deposit your coins to their wallets and they promise to give them back whenever you asked for them.
With a Decentralized-Exchange (DEX) like Uniswap, you can directly swap your coins from the safety of your personal wallet. Since providing liquidity is quite profitable, it stands to reason that there will always be enough tokens to swap… or are there?
Uniswap is operated on the Ethereum (ETH) blockchain and works through smart contracts. This means that every coin you want to swap must be compatible with the ETH blockchain (ERC-20 tokens).
As a liquidity provider (LP), you have to know that you will have to sign a few smart contracts before getting started and each one comes with a fee – to be paid in ETH.
There also are some risks involved, check out Uniswap‘s pages for more details on becoming an LP.
It is highly recommended that anyone interested dive deeper into this subject, DYOR (Do Your Own Research), and read some more of the resources provided on the Swapfolio/wiki section of the website for more tips and resources.
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We hope this has helped you to better understand how DEXs like Uniswap work and hope to hear from you soon!