Uniswap, the Market-Making Crypto "Unicorn"

Uniswap ranks among the top 10 exchanges in Fazzaco's monthly crypto exchange volume article​. Last month's data revealed that Uniswap v3 had a spot trading volume of $26.688 billion in January 2023, representing a M-o-M growth of 74.85% from December 2022's $15.263 billion. However, the data still falls short of November 2022's $36.168 billion.

As of writing, data from CoinMarketCap shows that Uniswap v3's spot trading volume over the past 24 hours was $1,002,873,407.24 (equivalent to 41,276 BTC), with a total trading volume of $1,080,911,172.42 (equivalent to 44,488 BTC).

In today's article, Fazzaco dives into the market-making logic that underpins Uniswap's AMM, as well as explores the similarities and differences between it and the traditional market makers in the forex market.

The Rise of The "Unicorn" Represents the Emerging DeFi

Typically, crypto exchange giants such as Binance are centralized exchanges (CEX). In a CEX, the trading of digital tokens closely resembles that of traditional finance, where the exchange plays the role of a matchmaker between buyers and sellers, much like a securities exchange.

​However, CEX faces two main issues: lack of anonymity and asset custody problems. For traders, every transaction executed on a privately owned CEX involves the participation of a third party. As a result, the transaction itself and personal info may be visible to the third party, and anonymity is not guaranteed. Furthermore, since CEX transactions are custodial, with the platform holding the assets being traded, security cannot be ensured. It is precisely because of these issues that decentralized finance (DeFi) has been able to gain ground.

Uniswap, established in 2018, is a standout among decentralized exchanges. Its v1 introduced the automated market maker (AMM) model, enabling anyone to pool assets into a shared liquidity strategy. In May 2020, Uniswap launched v2, and the AMM model experienced exponential growth. According to data from the Uniswap website, within less than a year of v2's launch, trading volume had exceeded $135 billion, making it one of the world's largest spot crypto exchanges.

In March 2021, Uniswap released v3. Liquidity providers for Uniswap v3 can build liquidity pools at three fee levels: 0.05%, 0.30%, and 1%. However, Uniswap v3 does not support leveraged or margin trading.

The AMM Market Making Logic Behind the Uniswap Protocol

Unlike traditional exchange architectures that require order books and counterparties, AMMs enable automated token trading. There are several types of AMM models, including Constant Product Market Maker (CPMM), Constant Sum Market Maker (CSMM), and Constant Mean Market Maker (CMMM). Uniswap utilizes the most widely used CPMM.

In Uniswap's model, there is a simple formula: x * y = k, where x and y represent the quantities of the two assets to be traded, and k is a fixed constant. Before trading begins, liquidity providers (LPs) inject the two assets into the contract.

Simply put, let's say crypto trader A wants to buy USDT with ETH on Uniswap. After logging in to the website and connecting to his Ethereum wallet, A selects the ETH/USDT token pair and inputs the desired amount to trade. A does not need to provide a buy or sell price, but only needs to determine the exchange rate and trading volume. Assuming there are 1,000 ETH and 10,000 USDT in the pool, and A wants to purchase USDT with 1 ETH. Uniswap automatically calculates the current price of ETH/USDT based on an automatic pricing algorithm and adjusts the price according to A's trading volume. If A's trading volume is small, the price adjustment is small, as the impact on the supply and demand of the assets in the pool is minimal. But if A's trading volume is large, the price adjustment is significant, as the impact on the supply and demand of the assets is higher. Thus, the price will change with increasing trading volume, and the supply and demand of assets in the ETH/USDT pool will change after the trade is completed.

Crypto AMM vs. FX Market Makers

In the forex market, many brokers act as market makers. So what are the similarities and differences between Uniswap's AMM and forex market makers, both of whom are market participants acting as liquidity providers?

Firstly, both are market makers that provide liquidity to other traders, thereby profiting from it. Secondly, both use their own quotes to form trading prices and facilitate trades. However, the trading methods and markets of the two are different. Firstly, AMMs are automated market makers that operate without human intervention, whereas forex market makers typically involve humans in quoting and trading. Secondly, AMMs are in the cryptocurrency market, while forex market makers are in the currency pair market.

The most significant difference between the two is their profit model: Uniswap AMM's profits come from transaction fees, while forex market makers' profits come not only from client commissions but also from some of the client's gains, losses, and risk returns. Lastly, the counterparties of the two are also different. AMM's counterparties are fully automated, while forex market makers' counterparties are traders. In summary, both are market participants that provide liquidity, but their differences lie in their trading methods, markets, profit models, counterparties, and other aspects. One could say that Uniswap AMM is like an emotionless robot, while forex market makers are more like personalized service providers who can make money for clients and profit from their failures.

Conclusion

The role of DeFi trading in cryptocurrency is becoming increasingly prominent, with the AMM represented by Uniswap V3 demonstrating its high flexibility and efficiency. As trading volumes increase, will the AMM face scalability and liquidity issues? Will it further explore more complex algorithms and models (such as v4 and v5) to meet growing demands? In addition, while DeFi protocols protect anonymity and avoid custody, they may also face regulatory challenges to security.

Furthermore, it is also worth exploring whether the AMM used in the crypto market may have more intersections with the FX market. Although there are many differences between the two, such as liquidity, trading population, and regulatory rules, with the influx of more institutional investors and more brokers starting to offer FX and cryptocurrency trading simultaneously, the two markets will naturally have more intersections and integration.