A Brief Guide to DeFi lending, Uniswap and other Automated Market Makers

Uniswap is an automated market maker (AMM) that is said to be the leading decentralised exchange. But to fully appreciate Uniswap, AMMs and decentralised finance (DeFi), it helps to first understand how traditional trading works using services such as Vanguard or Coinbase.

Traditional trading

When you buy a share (let’s say Apple) on Vanguard or a digital token (let’s say Bitcoin) on Coinbase, you are "hiring" Vanguard and Coinbase as a middleman. They take your money and buy the given asset off an exchange order book - a list of buyers and sellers. The price you get for the share or the digital token is the price another party has pre-agreed to sell or buy it at.

Traditional trading generally has these characteristics:

• There is a trusted middleman to execute your trades (Vanguard, Coinbase).
• There is an order book filled with buyers (bids) and sellers (asks) that determines the value of your trade.
• You don't directly hold your own assets - the middlemen hold them on your behalf.
• You are required to provide personal information and be known in order to trade.

Uniswap and other AMMs

AMMs allow digital tokens to be traded without the middleman. They are a financial tool unique to Ethereum and DeFi. They use mathematical formulas and liquidity pools to set the price of a digital token (which is explained in more detail below) instead of relying on the traditional market of buyers and sellers. Uniswap is the most popular AMM on the Ethereum ecosystem. Like most AMMs, Uniswap facilitates trading between a particular pair of assets by holding reserves of both. 

Uniswap differs from traditional trading as:

• There is no trusted middle man to make trades. You trade directly from your own Ethereum self-custody wallet (e.g. MetaMask) using the Ethereum blockchain. This is what makes Uniswap a decentralised exchange.
• There is no order book. The price for buying or selling is determined through automated market making, which is handled by smart contracts on the Ethereum blockchain (explained in more detail below).
• You directly hold your Ethereum-based assets in your own wallet. There is no custodial middleman.
• Your personal identity is not known or required when using Uniswap or Ethereum directly.

Liquidity Pools 

Instead of relying on buyers and sellers who pre-agree on prices to form an order book, AMMs like Uniswap incentivise investors (also known as liquidity providers) to pool their Ethereum-based assets into Uniswap smart contracts in exchange for a share of the transaction fees. When using Uniswap, investors receive 0.3% per transaction. These invested Ethereum-based assets are allocated to trades automatically by smart contracts based on the rules of the AMM protocol. As more trades are made, the investors accrue more transaction fees.

The exchange price of tokens in the Uniswap platform is determined by the ratio of funds deposited in a certain pool. In contrast, traditional exchanges determine the price of tokens based on supply and demand. Supply and demand is shown in the order book.

Every trading pair on an AMM has a liquidity pool – and anyone in the world can create AMM trading pairs or provide liquidity to them without permission. One of the most popular trading pairs on Uniswap is USDC-ETH. To become an investor in the USDC-ETH liquidity pool you must contribute an equal ratio of both assets into the pool: to invest $1,000 you would need to contribute $500 in USDC and $500 in ETH.

Investors are willing to pool their assets in AMMs, like Uniswap, because there is the financial incentive of gaining a share of the transaction fees. When investors want to cash out of a given pool, they simply trade in their Uniswap token and are given assets from the pool, according to their ownership percentage. Because of the accumulation of fees, the amount of assets you receive should be greater than what you put in.

Fraud Risks

There has been an increasing amount of comment on the issue of DeFi lending being vulnerable to fraud, as there is no middleman to monitor or regulate.  

Custodial exchanges hold huge sums of assets on behalf of users and are, therefore, susceptible to attack. When these attacks succeed, customers holding their assets at the exchange are often left powerless.

Uniswap, as a decentralised exchange, does not require you to give up control of your assets to trade. You can trade on Uniswap via Ethereum from the comfort of your own wallet. Yet it does lack verification. In August 2020, there was a copycat app on Google store which duped investors into entering their private keys. There is also a risk of fake tokens being traded on Uniswap exchange. Anyone can list a token on Uniswap, and its decentralised nature means there is no review process. This makes it easy to create a token with a name similar to a popular DeFi platform, and trick users into purchasing worthless tokens.

Possible Regulation

In the last year, we have seen the Financial Conduct Authority (FCA) attempting to regulate the more traditional digital assets on the blockchain, as it has taken on the role of anti-money laundering and counter-terrorism financing supervisor for UK cryptoassets companies.  It is clear from its work here, however, that the regimes in place at the moment are out-dated and ill-suited to the more traditional cryptoassets. So it is hard to imagine that the FCA would even begin to comprehend, let alone regulate, DeFi lending and the likes of Uniswap. 

That said, there are clear similarities between the activities of Uniswap and the likes of peer-to-peer or margin lending. If a project facilitates loans or interest payments to users, then it most likely qualifies as engaging in lending activity. Therefore, the FCA is likely to try to regulate DeFi lending at some point.