Decentralized exchange Uniswap has partnered with fintech company Moonpay to allow users to purchase crypto directly on the platform using their debit or credit cards or through bank transfers. According to Uniswap, this move will provide a safe and secure way for users to purchase crypto without relying on centralized intermediaries. Furthermore, it will also make DeFi accessible to users and somewhat remove the technicalities involved in DeFi trading.
Uniswap’s announcement comes when users’ trust in centralized exchanges (CEXs) is low following FTX’s collapse. Other CEXs like Binance have also come under intense scrutiny, which has led to many of them releasing their proof-of-reserves to alleviate customers’ fears. However, many believe decentralized exchanges like Uniswap are the way forward, which is why such a move from them is a good one. Here’s everything you need to know about Uniswap:
What is Uniswap? Everything You Need to Know About the Decentralized Exchange
Uniswap is a decentralized crypto exchange that runs on the Ethereum blockchain. Unlike Crypto exchanges like Binance and Coinbase, Uniswap is fully decentralized, meaning that a single entity doesn’t own it. Centralized exchanges typically rely on traditional order books to facilitate trading between their users. However, Uniswap adopts an automated liquidity protocol, an automated trading mechanism that enables the trading of digital assets using liquidity pools rather than conventional order books. Here, traders can automatically exchange one crypto asset for another on the blockchain. Furthermore, traders are incentivized to become liquidity providers by making their crypto assets available in the liquidity pools in exchange for a share of the transaction fees. In simpler terms, Uniswap is a democratized exchange of the traders, by the traders, and for the traders.
Uniswap is built on the Ethereum blockchain, which makes it compatible with all ERC-20 tokens (tokens created using Ethereum’s technical standard and ones that are live on the network). It is also compatible with wallet services like MetaMask. Uniswap advocates for self-custody, so users have total control of their funds at all times, unlike when using centralized exchanges. With this, users have no worries about an exchange using their funds like FTX allegedly did. It also eliminates the risk of users losing their funds if the exchange is hacked.
More on Automated Liquidity Protocols
As mentioned earlier, Uniswap adopts an automated liquidity protocol to provide liquidity to traders. Uniswap incentivizes users to lock up their crypto assets in a liquidity pool which is then used to facilitate trading on the decentralized exchange. Each token on the platform typically has its pool which users can contribute to, with the prices for each token determined by a math algorithm. The aim of this math algorithm is to ensure that there is a constant state of balance among the crypto assets in the liquidity pool.
Automated Liquidity Protocols eliminates the need for an opposite party to complete a trade, as is the case with traditional order books. Users can instantly execute a trade at a specific price as long as there is enough liquidity in the pool to facilitate the transaction.
The Role of Arbitrage Trading
Like Liquidity Providers, Arbitrage trading and traders are undoubtedly an essential component of the Uniswap ecosystem. Arbitrage trading involves the act of finding discrepancies in a token’s price across multiple exchanges and using this to secure profits. For example, Arbitrage traders find coins that are either trading below or above their average market price on Uniswap and trade them on other exchanges, making gains from the difference in prices. Arbitrage traders perform this act until that token’s price is similar to that on other exchanges. This action significantly contributes to keeping Uniswap token prices in line with the average market price.
Risks Involved in Using Uniswap
Before getting started on the decentralized exchange, it is important to be aware of the risks involved in trading on the platform.
The Automated Liquidity Protocol presents the risk of impermanent loss to liquidity providers. Tokens contributed by liquidity providers to the liquidity pool can lose their value or fluctuate in price based on the supply and demand for that particular token. Usually, that creates an imbalance in the liquidity pool, which could result in an uneven and lower reward, known as impermanent loss. For example, Bob, a liquidity provider, could provide ETH to the liquidity pool, but a higher supply than demand for ETH could drive its price down, which would mean that Bob would be getting his ETH at a reduced amount if he were to withdraw his funds at that point.
It is referred to as impermanent loss because it is only a loss if Bob, for instance, chooses to withdraw his funds instead of waiting for the token to retrace to his initial entry, thereby providing him with a profit from trading fees. However, that isn’t always the case especially with highly volatile tokens where your profits become permanent loss.
Liquidity Pools are Highly Vulnerable
The funds from liquidity pools are locked in a smart contract. As such, there is the smart contract risk in which hackers can exploit the smart contract that governs the pool. There is the possibility of these funds being drained if hackers can find a bug in the smart contract, leading to permanent loss of funds for the liquidity providers. Another risk is that these bugs could create a backdoor in the smart contract which leads to flash loan attacks. Flash loan attacks occur when the attacker borrows a huge sum from the platform without any collateral and uses the funds to manipulate a token’s price on one exchange and sell it on another.
Slippage occurs when traders purchase or sell a token at a price other than their desired one, which could result in loss for them. It usually occurs due to the volatility of the crypto market. Although slippage is also common in centralized markets, it is far worse in decentralized ones like Uniswap due to the imbalance in liquidity at different points in time. Slippage is not necessarily negative though, as a trader can trade a token at a better price than the one they were attempting to buy or sell at.
Uniswap runs on the Ethereum blockchain, which is famous for its high gas fees, especially with increased demand on the network. Gas prices are unstable, and there is no limit to how high they can get, which can be frustrating for traders, especially when their trade gets backed up or “stuck” in some cases. This instability in gas fees also makes traders and investors vulnerable to frontrunning attacks.
How To Get Started on Uniswap
To get started on the platform, you will need to connect your ERC-20-supported wallet like MetaMask, Coinbase wallet, Portis, or Fortmatic. Once that is done, you will need to add ETH to your wallet as that is what you will need to trade on the platform and pay for gas fees. After that, you can get started on exploring the various DeFi services which Uniswap offers its users. Following a recent development, NFT collectors can also trade NFTs on the platform.
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