Trading and Investing

Everything You Need to Know About Uniswap

Published
July 5, 2021
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    Most crypto trading occurs on centralized exchanges, such as Coinbase or Binance, using conventional order books. When you place an order to buy a cryptocurrency, these exchanges match you with a seller that wants to sell using an order book. The number of buyers and sellers at any given time is known as the market depth or available liquidity.

    Uniswap is a decentralized exchange, or DEX, that provides an alternative to centralized exchanges. Built on the Ethereum blockchain, the automated market maker uses an automated liquidity protocol to facilitate buying and selling without an order book.

    Let’s take a closer look at how the Uniswap exchange works, how to use Uniswap, what’s new in v3, and the tax implications to keep in mind for UNI crypto.

    What is the Uniswap Exchange?

    The Uniswap exchange is one of the most successful decentralized exchanges that are part of the decentralized finance, or DeFi, movement. The platform enables traders to exchange Ethereum tokens (ERC-20) without a centralized intermediary. At the same time, anyone can earn fees by lending their crypto to special reserves called liquidity pools.

    Uniswap Exchange
    Uniswap’s easy to use interface makes it easy to trade. Source: Uniswap

    Uniswap leverages an automated market maker mechanism that holds liquidity reserves instead of maintaining an order book. Liquidity providers, or LPs, deposit an equivalent value to two tokens—often stablecoins—into a liquidity pool in exchange for liquidity tokens—or UNI crypto tokens. These tokens are redeemable for the share they represent in the pool.

    The price is set based on the supply and demand of the liquidity pool rather than an order book. For instance, an ETH/USDT liquidity pool might have x ETH and y USDT for the total liquidity of k, where k is a constant value that never changes. Thus, if a trader buys 1 ETH for 500 USDT, they increase the USDT portion, and the effect on k determines the price they pay.

    The most significant risk for liquidity providers is divergence loss—or the opportunity cost of pooling tokens that increase in price. For example, a 2x price change in the underlying asset (e.g., ETH) translates to a 5.7% loss relative to holding the underlying asset. The loss occurs when the liquidity provider withdraws its tokens from the liquidity pool.

    The Launch of V3: What Has Changed Since Uniswap V2

    Uniswap bills v3 as the most flexible and efficient automated market maker ever designed with concentrated liquidity and multiple fee tiers. Despite some hiccups following its launch in May 2021, the platform promises to improve capital efficiency by providing liquidity providers with more flexibility and earning potential.

    Some key features of v3 include:

    • Capital Efficiency: Uniswap v3 enables liquidity providers to set custom price ranges that they want to provide liquidity for, leading to more liquidity in the price ranges that trading activity happens.
    • Optimistic Rollup: Uniswap v3 aims to address Ethereum’s high gas fees by deploying a layer two scaling solution known as an Optimistic rollup. The strategy should help scale smart contracts and increase transaction throughput, resulting in lower costs.
    • Non-Fungible Tokens: Uniswap v3 liquidity tokens will become non-fungible tokens (NFTs) since liquidity providers can specify their price range. A side-effect of these changes is that the tokens can no longer serve as collateral on Aave or MakerDAO.

    How to Use Uniswap?

    Uniswap is relatively easy to use for traders and investors that want to use it as an exchange. While the theory behind providing liquidity in v3 is a little more complex, the interface is still relatively easy to use. You can also click on the View v2 Liquidity button to add liquidity to v2 rather than v3.

    You can place a trade in a few steps:

    1. Visit Uniswap.org and click Use Uniswap.
    2. Connect your Ethereum wallet (e.g., Trust Wallet).
    3. Specify the transaction details (e.g., tokens to exchange).
    4. Click on Swap to preview the transaction.
    5. Confirm the transaction request and wait for it to finish.

    You can provide liquidity through the same interface:

    1. Visit Uniswap.org and click Use Uniswap.
    2. Click on Pool.
    3. Connect your Ethereum Wallet.
    4. Specify the transaction details (e.g., tokens).
    5. Specify the fee tier and price range.
    6. Deposit the amounts.
    7. Approve and add the tokens.

    Uniswap Exchange Tax Considerations

    The IRS taxes every crypto to crypto and crypto to fiat transaction, which means that all Uniswap transactions are taxable. In addition, with each transaction, you must calculate the cost basis and determine the capital gain or loss. These transactions are reported on Form 8949 and aggregated on Form 1040 Schedule D and potentially other tax forms.

    If you’re providing liquidity on Uniswap, you must pay taxes on the trading fees that you collect when you leave the liquidity pools. In addition, UNI tokens are taxable when they are converted back into ETH or ERC-20 tokens. Unfortunately, the IRS hasn’t guided on the tax implications of transferring crypto into liquidity pools yet.

    Finally, if you’ve used Uniswap, you can likely claim 400 UNI tokens per address that you’ve used Uniswap with as part of an airdrop. If you claim these airdrop tokens, you will owe capital gains tax on them with a $0 cost basis. So, for example, UNI at $20 per token would translate to an $8,000 capital gain and $1,200 in taxes at a 15% tax rate.

    ZenLedger makes it easy to calculate and pay taxes on all kinds of crypto transactions. After connecting your wallets and exchanges, the platform aggregates transactions and automatically calculates your capital gains and losses. You can even pre-fill popular IRS forms, including Form 1040 Schedule D and Form 8949, to provide to your accountant.

    Checklist of Other DEXs

    • dYdX is a trading platform for crypto assets that enables decentralized margin trading.
    • JellySwap is a cross-chain exchange powered by atomic swap technology.
    • Pancake Swap is a Binance Smart Chain based AMM with liquidity incentives.
    • SushiSwap enables users to swap any ERC-20 token into any other ERC-20 token through automated liquidity pools.
    • YOLO is a decentralized exchange that aims to provide a frictionless token swap experience on the EOS network.
    • WhaleEx is the EOS based DEX exchange with multi-signature smart contracts.

    The Bottom Line

    Most crypto trades occur on centralized exchanges, but decentralized exchanges (DEXs) are becoming increasingly popular. Uniswap is one of the most popular DEXs out there, and with the recent launch of v3, it could become even more popular. Of course, investors should keep taxes in mind when using the exchange to avoid any problems with the IRS.

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