ELI5: What is Uniswap?

Uniswap is the most popular DEX and Automated Market Maker available in the crypto world today. Around $1.6 billion USD is traded on the exchange daily, and it currently dominates a whopping 32% share of all decentralized exchanges.

Here users can quickly exchange all types of ERC-20 tokens with a browser wallet such as Metamask. New tokens such as SHIB or AMP debuted on Uniswap before going to bigger exchanges, meaning it’s a great place to get in early on low cap coins, or potential “crypto moonshots”.

Another reason Uniswap continues to be so popular is due to its decentralized, trust-less system. There is no order book, no interfering middle-man, no centralized exchange to enforce identity papers and tax requirements, and a lower risk for government interference. The result is faster, secure, and often times cheaper than a centralized exchange. With Uniswap being incorporated into many DeFi protocols, one could say that it lies at the core of the DeFi ecosystem.

But how does it work exactly? 

Uniswap facilitates the trading of ERC-20 tokens through its Liquidity Pools (or LPs for short). Each pool is made up of 50% of one token, and 50% of another token (for example ETH-USDC is a popular pair). The liquidity comes from providers who stake their tokens into the pools, and in return receive a share of the swap fees. Returns can be lucrative if the liquidity provider knows what they are doing.  LPs can also be a strategy for hodlers as they can earn passive income while waiting for the value of the two tokens to appreciate (this works especially well in a sideways, or crab market).

Exchanging ETH to FLY  is a quick and simple process with Uniswap and Metamask.

Understanding Liquidity Pools

Nevertheless, Uniswap has a steep learning curve. With so many factors to think about, it can be complicated for new users to understand how to choose a pool and remain profitable. Some things to take into consideration before entering an LP position include:

  • TVL (Total Value Locked)
  • Trading Volume
  • Fees collected per pool
  • Ethereum’s current gas fees
  • Impermanent Loss (the most dreaded and probably least understood issue, resulting from the diverging prices of two tokens)

New Features in Uniswap V3

Uniswap V3 had a timely launch in May 2021 in the middle of the bull market. 

Trading volume on V3 has already surpassed V2, with over $ 1.5 billion USD in trades taking place per day

The noticeable differences in V3 includes concentrated liquidity and the ability to choose between multiple fee tiers.


Uniswap V2 and V3 dominate the DEXes at 32%

Concentrated Liquidity & Fee Tiers

In the previous version of Uniswap, users provided liquidity from $0 to infinity. In V3, liquidity providers have increased control over their capital, and can choose to exchange between a range of prices. Providing concentrated liquidity gives the opportunity for a liquidity pool provider to make up to “4000 x” more than V2, according to Uniswap. At the time of writing, the top Uniswap earner has collected around $3.6 million USD in fees and the second top earner around $3 million USD.

One thing to keep in mind is that concentrated liquidity positions are most profitable if you already have a large amount of money to invest. This is due to its more complex smart contracts that lead to higher gas fees.  To make the most of these narrow trading ranges, they have to be adjusted often, which can add up over time and eat away at the profits of smaller providers.  

One solution for smaller providers could be to bridge coins over to the much cheaper Layer 2 (Optimism), which would mean only one pricier Ethereum gas fee to pay, rather than several.

As Optimism is a new feature, volume is still low, but is likely to grow in the near future.


Example: Depositing FLY-USDT tokens into Uniswap V3, and selecting the price range we would like the tokens to trade between. 

Providing Liquidity to Uniswap with FLY (Franklin)

  1. On the Add Liquidity page, select the tokens you would like to deposit to a liquidity pool. In our case we will select FLY-USDT, but there are also other options such as FLY-ETH.
  2. The next step is to select the Fee Tier by clicking “Edit”. Currently Uniswap offers three tiers with these recommendations:
  • 0.05%: Recommended for stablecoin pairs. As most users will prefer to pay lower fees when exchanging tokens you will likely make up for the low fee in volume.
  • 0.3%: Best for most pairs. Uniswap recommends this fee for uncorrelated pairs such as ETH-DAI, that will have some price divergence. The higher fee should help offset the risks of Impermanent Loss (LINK).
  • 1.0%: Best for exotic and less traded pairs, which have higher risk of price volatility

For FLY-USDT, we will select the 0.3% fee tier. If unsure, you can let Uniswap automatically select the best option.

  1. Next you want to set the price range. Here you should consider the ranges you expect the prices to move over the time span of your LP. When one token breaks out of a price range (which is likely in a bull or bear market), you will stop receiving trading fees until the price comes back to your range. This could mean you will have to start a new LP position and spend more on gas fees. Very tight ranges tend to receive more fees and can be more lucrative, but larger ranges are safer from the volatility of crypto. In our case we are selecting a trading range between $0.16 – $0.39 for the FLY-USDT pair (FLY currently sits around $0.24).
  2. Click to confirm your liquidity position-done!

Tools for LPs

The following tools can help you to analyze optimal price ranges for Uniswap V3 positions:

Uniswap Info.

Flipside Uniswap V3 calculator

Defi-lab.xyz

Chainvault.io

Non-fungible Liquidity (NFTs)

Uniswap V3 also has a fun new feature to create non-fungible tokens (NFTs). These are based on your LP positions, which are then converted into “digital artworks,” and can even be traded and sold like normal NFTs.


Uniswap v2 & v3 Differences At a glance

Uniswap V2Uniswap V3
LP positions range from $0 – infinity“Concentrated” Liquidity allows for a tighter range of prices to be selected
Only on Layer 1, means gas is not efficientUsers have options between Layer 1 and Layer 2 (Optimism) to save on gas
Favors those with larger amounts to invest (at least until ETH 2.0 solves gas issues)Favors those with larger amounts to invest (at least until Layer 2 has more liquidity and ETH 2.0)
Earned Fees automatically compounded into your LPsEarnings do not compound

Conclusion

Uniswap V3 sees many new and highly advanced features, alongside the chance to earn higher profits if the user understands the system well enough.

There is a lot of potential if one has time to mico-manage pool positions, and a large enough capital to afford gas fees when changing concentrated liquidity positions.  For those with less capital it is probably better to use V2 until the Optimism and ETH 2.0 roll out is complete, after which switching to V3 will bring more benefits.