What Is Uniswap Liquidity Pool and How Does It Work?

Quick Info

ICO was once a huge hit, as you remember. For a long time, this form of crowdfunding remained the main benefit of the blockchain. The main, although not the only one. Today marks the start of a whole new era. It’s called decentralized finance. In the spring of 2019, Forbes Magazine called the DeFi sector “a new dynamic that brought great vigor to the crypto industry”. Fair enough. Decentralized finance really became the trend of that time. What is more, it still continues to grow, rather than diminish. Today, we’re going to talk about the darling unicorn at the very center of the De-Fi movement — Uniswap. With that said, let’s get started.

Few Words about Uniswap Itself

Among the one thousand and one ways to make money in the high-risk sector, decentralized exchanges came to the fore. Uniswap is a true leader among leaders. It facilitates automated transactions between cryptocurrency tokens on the Ethereum blockchain with the help of self-executing contracts. The platform beat Coinbase, a digital currency exchange, by trading volume in August 2020. Keeping all this in mind, let’s aim to answer this simple question: How did Uniswap manage to challenge centralized exchanges?

The idea behind the project has a benchmark. It originated with Vitalik Buterin’s post on Reddit. The Russian-Canadian programmer described the concept of smart contracts in October 2016. These contracts had to manage the reserves of various tokens and balance their prices according to demand and supply. Hayden Adams, an American computer engineer, decided to put this idea into practice. Once he was in the team of Ethereum developers, Adams was trying to create an automatic market maker. Such “hobby” eventually earned him several grants and $100,000 from the Ethereum Foundation. According to Adams, the platform is based on the values of the Ethereum. All the functions of the smart contract are open and can be improved. Just for your information, the very name of Uniswap was also made up by Vitalik Buterin.

What makes the project stand out from the crowd?

• Full control over your funds. There is absolutely no risk associated with the centralized exchange where you can lose everything if it is hacked or it goes bankrupt.
• There is no central token.
• The lack of KYC. Uniswap isn’t keen to know its customers. Since the only person who controls your money is you, there is no need to go through the highly questionable procedure. Put your passport aside, you won’t need to provide your name or other personal information. This means you can start using the exchange much quicker than you could’ve imagined. It also significantly reduces the likelihood that your sensitive data will end up in the wrong hands.
• The platform doesn’t have a somewhat special relationship with the first contributors of funds. Everyone is equal.
• Low commissions. Uniswap charges a fixed commission of 0.3% per transaction which is considerably cheaper compared to most decentralized exchanges.
• Listing is free.
• Uniswap replaces traditional centralized market tools with automated liquidity tools executed purely by algorithms.
• The system does not use the order book to determine the value of an asset unlike common crypto exchanges, where the price reflects the principle of supply and demand.

Liquidity Pool Explained

A new type of decentralized marketplace combines tokens into self-executing contracts. In this way, it creates pools of liquidity. As a matter of first importance, you require some fundamental comprehension of this phenomenon. Here’s the simplest explanation with no metaphors or hyperbole. Liquidity pools are nothing but pairs of ETH and ERC-20 tokens. Traders can swap and exchange them. Users provide their token and receive another one in return. For this to work, the trading pair must have liquidity — the necessary supply of ETH and USDT.

Crypto lovers can exchange their assets in pools using Ethereum. The admirable, if not particularly mind-blowing, function of Uniswap is that any user can create new trading pairs for any token unlike traditional platforms, where the exchange itself dictates its terms for trading pairs.

People who add assets to the pools are called liquidity providers a.k.a. LPs. They are paid a proportion of the transaction commission for their work. Literally, anyone can deposit their Ethereum tokens and start earning! There is also no minimum deposit to join the pool. While it might sound like a pipe dream, you can begin with any amount (as long as it’s an exact 50% ratio between the two tokens). All you have to do is connect an Ethereum wallet (for example, MetaMask).

How Does It Work?

In the Uniswap project, all pools consist of two tokens. To create a pool (for instance, USDC/DAI, where 1 USDC will be equal to 1 DAI) you need to put DAI and USDC in the same proportion so that the ratio will be 1:1, e.g. 1000 DAI and 1000 USDC. Once again, it’s important to maintain the 1:1 rate.

If a trader comes to your pool and wants to take 100 USDC for 100 DAI, then it turns out that he will take 100 USDC and add 100 DAI. In this case, the ratio will change. There will already be 1100 DAI and 900 USDC. The ratio between tokens and their price will be completely different. This opens up the possibility of arbitrage. The next trader has the motivation to add back USDC and pick up cheaper DAIs. He can exchange them for a better rate somewhere else.

Back to the main point, there are two rules, on which the whole work of the pool is based.

Rule #1 — the pool is a constant.

eth_liquidity_pool * token_liquidity_pool = constant_product

If the first token is X, the second is Y, then their product is constant (after any trade).

Rule #2 — the price of the token is formed according to the formula below. Perhaps it can provide some real insight:

eth_price = token_liquidity_pool / eth_liquidity pool

If things get a bit complicated, here is an easier way to wrap your head around the liquidity pool. It can be compared to a scale. Let’s say, on one bowl there is the ETH, and on the other, the DAI. By taking DAI and adding ETH, we change the price of the DAI. The latter becomes more expensive, that is, ETH becomes cheaper. The thing is these scales show the ratio of two bowls and their product. Makes sense? We hope so. Let’s move on.

How to Add and Remove Liquidity

As an example, consider FNK-USDT. We should press the Add liquidity option first. It is located in the upper-right corner, next to the Trade button. Please note that to put FNK tokens to the pool, we will also need to add the USDT equivalent.

A popup will show you Prices and Pool Share: USDT per FNK, FNK per USDT, and Share of Pool. The latter depends on the number of tokens we enter in the input.

Let’s say you are ready to add 400 USDT to the pool. If Input is 400 USDT then FNK becomes 27.4488. Share of Pool is 0.01%. Press Connect Wallet. Choose the one that is suitable for you. Let’s say you choose WalletConnect. Scan the QR code with a WalletConnect compatible wallet. Afterward, press Supply. You will get 0.000103089 FNK/USDT Pool Tokens. In the window that appears, you will see:

FNK Deposited 27.3926.
USDT Deposited — 400.
Rates: 1 FNK = 14.6 USDT.
1 USDT = 0.06848 FNK.

Share of Pool — 0.01031%.

Press Confirm Supply. After this is done, a pop-up window appears saying “Waiting For confirmation”. You also have to confirm this transaction in your wallet. And after that, our transaction will be successfully confirmed. In turn, our tokens will be added to the pool. The status of transactions can be checked in the upper-right part of the site. Please remember that tokens can only be added to the liquidity pool in equal proportion. Unfortunately, you can’t add more FNK or less USDT. You can add coins in an equal ratio at the current rate.

On a more pleasant topic, every time you bring additional liquidity to the pool, you get the LP tokens. This happens automatically. These assets monitor your contribution to the cause. To get a reward for your efforts, it’s obligatory to remove liquidity first. Press the Pool button. In the appeared window, choose “Remove Liquidity”. Select the ERC-20 token for which you have brought liquidity. Afterward, the details of Pool Tokens, Balance, and Output will be viewed. Simply guide the mouse on “Remove Liquidity”, confirm the notification, and voila!

Concluding Thoughts

Now you have the main outlines of what the Uniswap liquidity pool really is all about and how it functions. Of course, you won’t become an expert overnight. Great feats take time — there’s no other way around it. You need to go into the project, examine it, give your heart and mind to everything that you have to find out. It may take a while but it’s worth it. Good luck!