Uniswap still represents DeFi’s number one decentralized exchange (DEX) two years post-launch. By maintaining and upgrading its automated market maker (AMM) protocol, the team succeeds in attracting swaths of liquidity across Ethereum’s DeFi ecosystem. And with Ethereum’s merge completed, lower gas fees might bring investors back to DEXs.
In this article, I’ll walk you through the UNI token and the tokenomics surrounding it. But before you learn about how the token is distributed and what role it plays in the protocol, I’ll first give you a quick rundown about Uniswap.
What Is Uniswap?
Uniswap is a DEX that operates an AMM. The mechanics of an AMM revolve around the fact that smart contracts can hold liquidity, and that their decentralized nature allows users to trade cryptocurrency without being subjected to KYC or having to register an account – evading most limitations imposed by centralized entities.
AMMs create smart contract-based liquidity pools (LP) which hold two cryptocurrencies in a 1:1 ratio. You can think of the LP as a trading pair that functions without the help of an order book. When a trader interacts with the LP, he provides one token to receive another one in return. The investor must take and receive the same dollar value in order to keep the LP stable.
What does this mean in practice? If I have USDT and want to buy Ethereum, I must give enough Tether that equates to the dollar value of a certain number of Ether tokens. If Ethereum is valued at $2,000 and I want to buy 0.5 Ether, I need to provide $1000 in USDT.
The same logic is applied when you provide liquidity to an LP for passive yields. You provide an equal dollar value of two tokens in order to keep the LP stable. This system is expressed by the constant product formula which Uniswap uses to define a trading pair’s price:
x * y = k
Uniswap’s AMM model is made possible by the symbiosis of three entities: traders, liquidity providers, and arbitrage traders.
Liquidity providers deposit liquidity to LPs in return of rewards. They essentially supply the liquidity needed to make trading possible in the first place.
Traders come to Uniswap to experience the bliss of decentralized trading. In return for trading, they pay a certain fee that goes to LPs as their reward.
The arbitrage is the silent player working in the background. He ensures that a LP’s price is accurate and close to CEX prices by constantly trading arbitrage opportunities – thus minimizing price differences between LPs.
The Uniswap protocol has a native governance token named UNI. This token was airdropped to everyone who traded cryptocurrency on Uniswap prior to September 2020. The team minted a total of 1 billion UNI tokens at genesis – a portion of which will slowly be unlocked through a course of 4 years.
The original distribution was done in the following manner:
Team, investors, and advisors have a four-year scheduled vesting period during which tokens are gradually unlocked. This ensures the price stability of the UNI token, and that all three parties act in good faith – which basically translates to working on Uniswap for the long-term.
After the vesting period ends, Uniswap releases an annual 2% inflation that ensures that everyone continues to participate and contribute to the Uniswap protocol. Obviously, the inflation rate has a negative effect on passive Uniswap holders. The inflation lasts perpetually.
Around 12,000 addresses that have ever initiated a transaction on Uniswap – even if it failed – were eligible for a 400 UNI airdrop per address. The remaining tokens were distributed to liquidity providers and investors who held UNI Socks.
While 15% of the community tokens were airdropped to Uniswap users and liquidity providers, another 43% went to the governance (community) treasury. This treasury distributes UNI on an ongoing basis through community initiatives, liquidity mining, contributor grants, and other programs. Tokens held inside the community treasury will also be vested on a 4-year basis.
The UNI token is exclusively a governance token. Governance is a mechanism in which DeFi protocols confirm their decentralization by delegating power to the community – AKA those holding the governance token. You can exercise your voting rights by locking UNI and voting on governance proposals or submitting new ones.
Besides voting, holders also have ownership over the UNI community treasury and have the power to enact a protocol-wide fee switch.
Of the 1 billion UNI tokens minted on genesis, 430 million belong to the community treasury. This treasury collectively belongs to all UNI holders.
The protocol also features fee switches that allow UNI holders to receive income based on the fees generated by the protocol. For example, Uniswap V2 has a fee switch that would reduce LP fees from 0.3% to 0.25%. Uniswap would give the remaining 0.05% to UNI holders if the switch was enabled. Uniswap V3 has a much larger fee switch that can charge anywhere from 10% to 25% from the LP.
Uniswap has one of the most active governance communities. UNI holders are free to participate on an online and public forum where they can share their thoughts and discuss the protocol.
As a UNI holder, you can vote on proposals and submit proposals of your own. In order to participate in governance, you must cover the UNI tokens needed to vote, ETH needed for transaction cost, and must own a non-custodial wallet (e.g. Metamask).
The governance process takes place on Uniswap's governance forum. You can find proposals under consideration, gather information about Uniswap's future, or simply engage with the community and discuss ideas.
A governance proposal taking place is marked as 'active' on the forums. The proposal showcases all information and documentation needed to understand the proposal and its effects on the protool. You can also view a community discussion focused on the proposal. You can support the proposal by voting for it, or make sure it doesn't pass by voting against it.
By the time a proposal is in its voting stage, it will already be backed by a smart contract that will execute its code once the proposal passes. The smart contract is open-source and publicly available. Most of the time it is also audited in order to ensure that the code isn't malicious.
To have the opportunity to vote, you must first delegate your UNI tokens. Delegation means entrusting your tokens to another address that will vote in your favor. This address can be your own, or another user who you believe can represent your interest. If you self-delegate, you can visit the Uniswap voting dashboard and vote on a proposal.
Keep in mind that a proposal must reach a quorum in order to pass. 1% of all UNI tokens must be cast in favor to submit the proposal, and another 4% for it to pass the vote.
You can execute your vote by either clicking 'vote for' or 'vote against' on the governance portal.
Uniswap is a brilliantly designed DEX AMM that dominates DeFi markets still to this day. The protocol has a bright future ahead if Ethereum developers manage to resolve the problem of high gas fees by working on proof of stake, sharding, and L2 scaling solutions.
The protocol itself is fully democratized and allows its holders to control its future through governance. All UNI holders are eligible to participate on the protocol’s governance forum and cast their vote for or against a proposal.
In the future, holders might decide to turn on several mechanisms for distributing tokens from the community treasury to holders. This would mean that a portion of the fees charged to liquidity providers go directly to UNI holders. Doing so would grant more value to the average passive token holder and create incentives far beyond governance.
If you want to learn more about DeFi protocols, I recommend reading the following articles:
Marko is a crypto enthusiast who has been involved in the blockchain industry since 2018. When not charting, tweeting on CT, or researching Solana NFTs, he likes to read about psychology, InfoSec, and geopolitics.