Uniswap or the Rise of Decentralized Crypto Exchange

Crypto - Decentralized Finance - Decentralized Exchanges - Ethereum - Permissionless Protocol - Tokenization

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The crypto industry has recently entered yet another bull market. The global crypto market cap is estimated at around $1tn, driven by Bitcoin's $600bn market cap. Thousands of news coins are emerging in a vast movement of tokenization of everything. Tokens represent the digital ownership of property rights. There are easy to create, manage, program, store, and trade, which is a revolution compared to paper-ish property rights.

Most of these tokens are created on the Ethereum blockchain. One of the key differences with Bitcoin is that Ethereum can execute Turing-complete scripts. It means that the Ethereum Virtual Machine can execute and host complex applications. I must say that I'm no Ethereum fan. I run a Bitcoin and a Lightning node, and I appreciate the simplicity of their design and their security. Ethereum has a very complex architecture that has facilitated many costly hacks. Having said that, I'm often blown away by the innovation in the Ethereum ecosystem, especially around tokens offering and trading.

One of these innovations is Uniswap. It's a decentralized cryptocurrency exchange (DEX) that operates on smart contracts hosted on the Ethereum blockchain. It's today the fourth-largest cryptocurrency exchange overall by daily trading volume. It means that its ~300-lines of open-source code are challenging centralized exchanges with thousands of employees such as Coinbase, Kraken, or Binance. Uniswap is the leading project in decentralized finance (Defi), which relies on smart contracts instead of financial intermediaries.

Uniswap works with a system of non-upgradeable smart contracts. It means that once launched, it can't be stopped. It's a decentralized and censorship-resistant financial product that allows people to trade freely. Uniswap works as an automated liquidity protocol. Liquidity providers supply a pair of tokens, proportional to the current price, in a pool. In exchange, they receive their pro-rata of the 0.30% fees Uniswap charges for every trade. This incentive mechanism has attracted $3bn in liquidity today. Interestingly enough, the protocol doesn't have an order book. The latter requires intermediary infrastructure to host the order-book and match orders and require the participation of market makers. Uniswap uses an automated market maker mechanism (AMM), which is more suited to blockchain development.

In 2 years, Uniswap has stormed the DEX market and seized 50% market share by volume. There is currently $3bn in overall liquidity, mostly in Ether ($1bn) and stable coins such as USDC ($268m), USDT ($221m), and DAI ($100m). Approximately 100k traders use the Uniswap protocol weekly for a volume of over $1bn per day. Overall, 757 000 unique addresses have already used Uniswap. These are huge numbers, and the growth is still steep.

Uniswap has many advantages. It is a permissionless protocol meaning everyone can use it as long as traders have crypto. You don't need a bank or even to comply with any regulations such as AML or KYC. Because it lives on the blockchain, the protocol is unstoppable, and it has a 100% uptime. Its gigantic liquidity allows for large trades with a very slick user experience. You can complete a trade on Uniswap faster than you can load the home page of your centralized exchange. Another difference is that anyone can add a new token into Uniswap, whereas it can take months for centralized exchanges to do so and up to $250k per token. Finally, thanks to its non-custodial policy and the in’ instantaneity, Uniswap is probably more secure than any other exchange. All of that combined makes Uniswap is a great product.

Like every great product, Uniswap faces challenges. The first one is that it can be expensive to use Uniswap. On top of the 0.3% fees, traders have to pay Ether gas to use the Ethereum blockchain. Uniswap is the product consuming the most Gas, with roughly $32m per month. If the network is congested, it will get expensive to trade on Uniswap. Today, it costs an average of $10 to trade on Uniswap. This scaling issue might be solved by Ethereum2 who might come in two or three years. Another annoying thing is that there are no order books, limit orders, stop orders, and other instruments. Traders have thus to tolerate market buy and price slippage, for which the default on Uniswap is 0.5%.

Uniswap is a great product with a great history. Hayden Adams developed it following Vitalik Buterin's idea. With the community's help and a $100k grant from the Ethereum foundation, one guy developed a secure, decentralized, censorship-resistant, and permissionless protocol. How amazing it is! Before Uniswap launched its token, it attracted $11m in investment from Andreessen Horowitz, Union Square Ventures, Paradigm, and others. The team has now grown to 11 people and is hiring. These 11 guys run a protocol that generates roughly $3m of fees for LP per day. The current smart contracts allow for the possibility of spiting the 0.30% fees between 0.25% for LP and 0.05% as a protocol-wide charge. Uniswap didn't activate the protocol fees yet.

There are many regulatory issues before turning on the 0.05% fees. One of them is to convince the authorities that the team isn't running an unstoppable multi-billion unregulated exchange. Uniswap's team had done its best to emphasize that it's an open-source project led by its community and that it's a protocol and not an exchange. Most arguments aren't convincing, but the authorities are still far from understanding what is happening on the internet. Collecting hundreds of millions of fees per year, as a protocol charge, might be risky. Other protocols such as Curve or 0x charge fees are sometimes redistributed to token holders. This is obviously smart but creates other regulatory hurdles because the token can be seen as securities. Anyway, the crypto industry at large is benefiting, like the internet before, from an absence of regulation that allows wild innovations to push humanity forward.

Uniswap keeps evolving. Last year, Uniswap v2 was launched. It contains significant innovation, such as the possibility of pooling two ERC20 tokens versus ETH-ERC20, an on-chain price oracle for Defi to stop relying on off-chain information or flash swaps. Uniswap v3, currently under development, will probably sit Uniswap’s domination even more.

There are many questions regarding the future of such a protocol. Among them, how many protocols can survive? Will it be a winner-takes-it-all like with any other protocols? Uniswap quickly replaced former leading protocols such as 0x or Curve. Maybe Uniswap is the winner, or maybe a new protocol will soon emerge. Also, will such a protocol be able to capture fees for token holders? It might be risky compliance-wise, and the protocol can always be forked by a team promising not to take such fees. In fact, Uniswap was forked into Sushiswap who now has 21% of the market share by volume. This is wild. Another possibility is that Defi moves from Ethereum to the Bitcoin blockchain over the next decade. Even the underlying layer 1 isn't safe from disruption!

Creating value versus capturing value is very different. Maybe these protocols won't capture value for their developers. Value capture might happen on top of the protocol. One of the many interesting businesses is decentralized exchange aggregators who face users and use whatever protocols to execute a trade order. They can be the ones capturing the value. Anyway, the innovation and value creation on top of this kind of protocol seem limitless. The tokenization of property rights is such a big revolution for the financial and legal industry and, more broadly, for the world!


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