Learning DeFi from beginning

I am an MPhil student who finds out that DeFi is tremendously interesting. However, when I started to get into this field, there are fewer materials for beginners to know. Here I post my final project paper from one of my courses and hope that will help you.

By the way, AMM is a hard-coded pricing mechanism, so there are many ways to improve it. And I am looking forward to having study partners and we might build the next largest DEX together!

Uniswap: The Sharing Economy in Decentralized Exchanges

Since the collapse of centralized exchange FTX, the safety and security of digital assets stored in centralized exchanges have been called into question. After declaring bankruptcy, FTX immediately claimed that the company had been hacked $415 million crypto assets from exchange’s account (Goswami 2023). And the Crisis of FTX brought Investors to Decentralized Exchanges (DEXs).

DEXs enable peer-to-peer cryptocurrency trading and provide financial services directly from users’ compatible crypto wallets, without forcing users to deposit their assets into a central custody account. DEXs believe in “Not Your Keys, Not Your Coins”, so clients in DEXs always control their private keys, which increases their confidence in their assets’ safety. DEXs have seen a significant surge in popularity in recent times, outpacing their centralized competitors. Decentralized exchange trading volume has already surpassed $91 billion in November, a 79% rise over the entire month of October 2022. (Shimron 2022). Uniswap is the leading DEX by trading volume and number of users. Founder Hayden Adams recently posted on Twitter that Uniswap surpassed Coinbase in daily volume for the ETH/USDC trading pair (Hayden 2022 Twitter).

Uniswap is a decentralized exchange system that enables users to “swap” their chosen ERC-20 tokens in the deposit pool, each pool containing one pair of tokens. Without relying on limit order books, Uniswap has its pricing mechanism named Automated Market Maker, which astonishingly precisely predicts the relative price of tokens outside the pool when compared to other bigger exchanges. And with Uniswap, anyone could begin functioning as a liquidity provider by putting their assets in the pool and receiving compensation for contributing liquidity.

In this passage, we briefly discussed the development of Uniswap in prior to introducing its price mechanism Automated Market Maker. We take into account the viewpoints of three key participants who are traders, arbitragers, and liquidity providers, and provide examples with numbers in order to help you have a thorough understanding of the key concepts. Additionally, we will explore the underlying mathematics of DeFi to provide a comprehensive grasp of how Uniswap operates. Through this exploration, hopefully you will be able to gain a deeper understanding of the nuances involved in utilizing Uniswap to its fullest potential.

Contents:

1. The Development of Uniswap

2. Liquidity Pool Mechanism

Automated Market Maker (AMM)

AMM in Uniswap: Constant Product Market Maker

Slippage in Uniswap

3. Traders

4. Arbitragers

Arbitragers’ Significance in Uniswap Pricing Mechanism

Optimal Arbitrage Problem

Flash swap

5. Liquidity providers

Impermanent Loss

User Experience in Uniswap V3: Add Liquidity

6. Summary

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