Uniswap is a decentralized Ethereum based protocol where traders can swap one coin for another. On the other side of the market, liquidity providers deposit coins into the liquidity pool in return for a percentage of the transaction fees.
Most beginners are familiar with swapping coins on an exchange, they just connect a wallet such as Metamask, and swap any coin in the wallet for another coin in the pool, a transaction executed by the Automated Market Maker (AMM). The swapper pays the “gas” or transaction fees.
On the other side of the marketplace, liquidity providers depositing pairs of coins into the pool in return for a percentage of these transaction fees.
Click on “Pool” in the navigation bar to see the list of returns offered, always in pairs, such as USD/ETH. Each pair is its own liquidity pool and shows the estimated percentage of the transaction fee depositors will earn. They must deposit 50/50 of each coin into the pool.
Note that the percentage is not the return but the percentage of the transaction fees, which Uniswap has fixed in three tiers based on the risk to the depositor.
You can also see total liquidity locked into any pair next to the list, and the volume of transactions. So investors holding USD and ETH, a stable coin dollar and one of the most held coins, have deposited around $1 million in the pool, with $9 million in transaction.
Investors simply click on “Add Liquidity,” select two coins they hold in their connected wallet to start earning.
Risk factors: Impermanent loss
As with all crypto, if the smart contract software is flawed or hacked, the depositor can lose money. Impermanent loss, however, is a risk inherent in DeFi exchanges.
Since the demand for two coins can fluctuate within the pool itself, the price of a coin within the liquidity pool can drop below the price on a regular exchange. With two coins, it may not move as fast as multi-coin pools on Yearn. Finance, however, if the price of one coin moves up rapidly relative to the second coin, it can cause that price to drop below the price of the coin on external exchanges, eliminating profits or resulting in a loss, which becomes permanent if the coin is withdrawn.
Limiting risk
To limit risk, choose trading pools that have a high correlation – that is, if the price of one goes up, it is likely that the price of the other will go up, too. On the other hand, if the price goes down, the price of the other goes down too.
Examples of correlated pairs include pairs of stable coins, since their price rarely varies, and pairs of different versions of the same coin, such as WETH and synthetic ETH.
Wrapped and synthetic ETH, while not the same, are both tied to the price of the coin: The first is one-to-one and the second is derivative, but essentially they move together.
ETH and WBTC have less correlation. And, if you deposit a pair like ETH and USD, ETH may fluctuate up and down while USD, as a stable coin, will not. Coins that are very volatile, considered exotics, may be impossible to predict and are highly risky.
The fees traders pay to swap coins are fixed in three tiers on Uniswap v3, based on these risks to liquidity providers: Traders pay .05% for swap for stable coin pools like DAI/SUDC, .3% for standard non-correlated pair and 1% for non-correlated exotic pairs, such as ETH plus an unknown token, to compensate of the risk of impermanent loss.
Setting the price range
Uniswap v3 also allows Liquidity providers to earn more yield by narrowing the range of price so that you only earn fees if the asset is trading within that range. This requires a more advanced understanding of price ranges.
Pro’s and con’s
As you can see, there are a number of pro’s and con’s of earning passive income on Uniswap:
Pro’s
- It’s one of the largest and relatively mature exchanges with a huge trading platform
- For pairs of highly correlated coins, you can earn passive income in addition to your bet that the value of the coin will increase
Con’s
- Due to the risk of impermanent loss, it may be safer to keep your coins in your wallet
Best videos from Kieran Mulholland – Decentralized Lifestyle
Video: https://www.youtube.com/watch?v=C4QaLIHR0kY
Glossary
Concentrated liquidity – Creating a customized price range to earn higher fees.
Correlated pairs – Two coins that are likely to move up and down in price together
Exotic pairs – Cryptocurrency that is not widely used, and has limited liquidity paired with a larger coin
Forks – A fork can be what happens when a blockchain diverges into two different paths forward or any change in protocol that validates or invalidates certain kinds of transactions
Slippage – A price that is less than the expected price due to a variety of factors
Synthetic coin – Cryptocoins that are related to the price on another coin or index, like a derivative,
Wrapped coin – A coin created to trade one-to-one based on the exact price of another coin.
Next Module: How to deposit into Uniswap liquidity pools