Since its early days, the crypto world has often been criticized for enabling permissionless, decentralized networks with their unique coins and tokens that are, however, only tradable via centralized exchanges. Subsequently, attempts were made to create decentralized order books directly on the blockchain. However, due to the inherent scaling limitations of blockchain technology, these ventures never really took off and no meaningful competitors to centralized crypto exchanges emerged. 

With the advent of Uniswap, this changed drastically. For the first time, Uniswap’s innovation provided an efficient and user-friendly way to swap tokens in a decentralized manner. It’s innovative approach leaves out order books completely and instead works with ‘automated market maker’ (AMM) protocols. AMM are smart contracts holding liquidity reserves, often referred to as liquidity pools, that traders can trade against. A pool generally holds one currency pair, e.g. Ether and Uniswap (ETH/UNI). These pools are filled by liquidity providers and anyone can participate in providing liquidity. To participate, the equivalent value of two tokens, i.c. ETH and UNI, have to be deposited in a pool.

A trader wanting to swap ETH for UNI now sends ETH to the pool and receives the equivalent value back in UNI tokens or vice versa. Unlike in traditional finance, there is no official exchange rate for a token pair, but the protocol automatically adjusts the exchange rate of a pool depending on the token ratio in the pool. The more the ratio deviates from the original 50/50 ratio, the more expensive the underrepresented coin gets in comparison to the overrepresented one. This mechanism is simply based on supply and demand. As each pool works insulated from others and from the market as a whole, price deviations are smoothed out by arbitrage traders, which utilize exchange rate disparity among pools, platforms as well as between the pool and the market.

For each swap, traders pay a small fee to the liquidity providers. The more volume a pool generates, the more fees liquidity providers earn in return. But, as anyone can participate in providing liquidity, high returns won’t go unnoticed by the market and attract more liquidity providers. Usually, returns are fairly high though, but no without reason. Providing liquidity can come with significant risk. If the prices of the two tokens in a pool don’t develop at the same pace or in opposite directions, the better performing token will slowly get drained from the pool because the exchange rate within the pool usually lags behind the real market rate on centralized exchanges. Arbitrage traders will therefore swap tokens in the pool until the exchange rate in the pool reflects the real market rate again. As a result, the pool and its liquidity providers are left with more of the underperforming and less of the overperforming tokens. If the token’s exchange rate doesn’t bounce back to the original ratio, the liquidity providers are left worse off and speaking in financial terms it would have been better for them to simply hold the two tokens in their wallets. In the literature, this effect is known as impermanent loss.

Therefore, as a liquidity provider, carefully select your pool and the coin pair, have a rough idea of the tokens possible future price developments and be aware of the risk of impermanent losses. Alternatively, liquidity can be provided to stablecoin pools, e.g. USDC/USDT, which have fixed exchange rates and therefore no risk of impermanent losses but also generate lower returns. 

In general, AMM protocols are a huge success so far. Uniswap consistently ranks among the top fee generators on the Ethereum blockchain and with an all time volume of over 300$ billion USD and over 57 million trades since its launch, it has become one of the cornerstones of today’s DeFi world.