Understanding Token #1: Uniswap (UNI)
Why buy the Uniswap Token? What value does it have?
Welcome to the first post of Tokenomics.
In this series, I hope to educate readers, and myself, through research, on understanding the use cases and economic value of Crypto Tokens.
Crypto is still nascent, but rapidly maturing, and many assets do not have to be valued purely on a speculative basis—they often offer cashflows or other intangible benefits, such as Governance Rights.
Today, I would like to explore Uniswap’s token UNI:
This is considered a “Blue Chip” Token by the community due to it being tied to the widely-used, valuable Uniswap Protocol. It’s also ranked in the top 20 by Market Cap on CoinGecko.
Before understanding the value of the token, it is important to understand the Uniswap Protocol, since the value of the token is ultimately derived from the value of the protocol.
For the impatient however…
TL;DR: The UNI Token entitles the holder to obtain ~1/6 of the current yearly $3B in trading fees paid to the Uniswap Protocol; however holders do not currently receive this—they must turn this fee switch on via Governance Controls. Given the circulating supply is valued at <$10B, UNI holders can buy into a rapidly growing protocol at <20 times annual earnings.
Understanding the Uniswap Protocol
Uniswap is a decentralized automated liquidity protocol, or Decentralized Exchange, DEX for short, on the Ethereum Blockchain.
What does any of that mean? Well, it basically means you can use Uniswap to buy and sell any tokens. Since it’s a crypto-protocol, it’s also secure and censorship resistant.
How is this being accomplished? Unlike traditional exchanges with order-books, where various participants offer to buy and sell at certain prices, Uniswap uses a x*y=k curve to price trades.
Explaining Automated Market Making
A Simplified Example1: Let’s say a pool had 20 Uniswap tokens and 500 USDC tokens. 20 * 500 = 10,000.
This K (10,000) must remain constant. Let’s say we want to sell 2 Uniswap tokens. This means we are adding 2 Uniswap tokens to the pool and removing some USDC tokens.
Since there will be 22 total Uniswap transactions and K must remain at 10,000, we can see that the remaining USDC will be 10,000/22=454.5. Since there was originally 500, we took out about $45 worth of USDC by putting in 2 tokens, or $22.50 per token.
Wait, wasn’t each Uniswap Token originally worth $25 in the pool? You thought you might get $25 and only get $22.50, 10% less than you expected! Indeed, but the further you move along the curve, the greater the price movement. This is why Uniswap is called an automated market maker. The price automatically shifts in response to trades and liquidity providers do not have to constantly update their prices.
The difference from normal market makers in traditional finance can’t be overstated. These are generally updating bids several times a second and here we have a way of market making where the liquidity provider can leave their capital in for an indefinite amount of time.
Why do Liquidity Providers (LPs) put tokens in the pool?
To make money of course! Uniswap v2 automatically applied a 0.3% fee to all trades, e.g. if you traded 100 ether for some USDC, it took 0.3 ether and kept it in the pool.
Why use a DEX instead of a Centralized Exchange (CEX)?
Well of course, there’s standard crypto reasons: secure, anonymous, censorship resistant, and an easier UX.
However, in DeFi, we don’t need to focus on standard crypto advantages. Decentralization and building in the Ethereum Ecosystem offers large product advantages that CEX’s cannot meaningfully compete on.
Providing liquidity and creating new pools is permission-less. By being on Ethereum, other projects can easily integrate Uniswap as a way to launch their tokens to the public. There’s also 0 counterparty risk. When you trade token A for token B, you interact with a smart contract and can verify that the smart contract has said tokens. On a CEX, the exchange could get hacked and you lose all your tokens.
Furthermore, recently, DEXs have proven to be more resilient in flash crashes than CEXs. DEXs have remained available to use while several CEXs were unable to be accessed.
How successful is Uniswap?
Uniswap was the first large DEX. It has consistently maintained around a ~50% market share:
Judging on different basis, such as unique addresses interacting with exchanges, it holds up extremely well.
By any reasonable metric, Uniswap is clearly the #1 Exchange.
Understanding the Uniswap Token (UNI)
Now that we have an understanding of the protocol, let’s examine UNI, the Uniswap Token.
1 billion UNI were minted at genesis and are planned to be distributed over 4 years.2 About 60% will go to community members and the remaining 40% go to employees, investors, and advisors. After the 4 years, there will be a perpetual 2% inflation rate.
What do UNI Holders have a right to?
The important 3 things UNI holders have a right to is:
Voting on Uniswap Governance Proposals
Collective Ownership of UNI Community Treasury (controlled by Governance Proposals)
Protocol Fee Switch
#3 is the most obviously important to UNI, but understanding #1 is key to unlocking #3.
Currently, and by default, the fee switch is off. UNI holders can vote to turn it on.
However, before we start exploring how much value UNI holders can extract from the protocol, let’s take a look at how much the protocol is making.
Uniswap Revenue
Uniswap’s almost exclusive3 source of revenue is fees for orders. Uniswap v2 offers 1 fee tier: 0.30% on all trades and Uniswap v3 offers 3 tiers: 0.05%, 0.3%, and 1.0%. For v3, LPs can choose which fee tier to provide liquidity in.
Uniswap v2 is at a $2B annualized run rate. Uniswap v3 has similar amounts of volume as v2 currently, but a significant portion is on the 0.05% fee tier.4 We can conservatively estimate v3 fees at $1B annualized. Together, the protocol is generating over $3B yearly.
DEX trading volume is growing exponentially: a naive linear extrapolation is almost surely incorrect.
There are a few countervailing forces:
Currently, trading on Ethereum is extremely expensive, the gas fee for a standard token swap is often $25+. Only whales can participate at a reasonable price since the gas fee comprises a smaller % of their overall trade.
Layer 2 Scaling (L2) is expected to arrive soon, with dramatically lower gas fees, and Uniswap has already said they will be deploying on L2. This will surely increase overall trading volume.
On the other side, competition is fierce and centralized exchanges often offer lower fees: It is unlikely a 0.3% fee remains the norm long term.
The Fee Switch
Now, currently, UNI holders do not accrue any of the fees generated from trading. However, the protocol has 2 different fee switches:
V2 has a fee switch that can reduce the LP’s fee take from 0.30% to 0.25% and route the remaining 0.05% to UNI holders.
V3 has a fee switch that can take anywhere from 10%-25% of overall LP fees as opposed to the fixed 16.67% for the V2 switch. Furthermore, the fees can vary by pool. This is a great pricing tool: Since Uniswap is the largest DEX, it can extract more value from the long tail of pools it is more likely to have and price more competitively for the extremely common trading pairs, e.g. ETH-USDC.
Governance to Turn on the Switch
This is an extremely complicated topic and I’m going to link to a detailed walkthrough of the topic.
In short, although 60% of UNI is said to go to community members, individual members will only hold about ~17% of UNI. The remaining 43% is held in the governance treasury which is collectively owned by UNI holders. This means that the total UNI outstanding is actually 57% of the original amount. Within this 57%, investors + team members control 70% of the voting rights, giving them a majority over governance.
This sounds worse than it actually is. As the article explains, starting centralized and undertaking a gradual path to decentralization is probably the best move.
Uniswap is operating in an extremely competitive, fast-moving market and they need the ability to innovate & respond quickly.
Uniswap is also not some anonymous team that is likely to pull rug out at any time. They’re a highly-trusted and well regarded member of the community.
In Crypto, smart contract based truth isn’t the only thing that matters. Sure, Uniswap investors + team members control 70% of the voting rights and could theoretically vote themselves the 43% of UNI tokens held in the treasury, but imagine what this would do to the project. This would be highly value destructive and cause the community to lose faith in the project, thereby destroying the value of the token.
Understanding the Treasury
Of the 1 billion tokens overall supply, 43% belongs to the treasury which belongs to the UNI holders. This means that for analyzing the value of the token, we should be evaluating the 57% of UNI tokens. After all, these 57% of UNI tokens actually collectively control the remaining 43% in the treasury.
Of the 570 million total tokens, at a current valuation of ~$17, we get a $9.7 billion circulating valuation.
How much Value can UNI Holders Obtain?
While buying the token at a $9.7 billion valuation, the primary question to think through is how much can I obtain?
We previously arrived at $3B+ in yearly fees. How much can UNI holders obtain though? What would be a decent example?
We actually have a great example, SushiSwap. SUSHI holders already can stake their tokens to earn 0.05%, very similar to the Uniswap v2 fee switch.
For simplicity, if UNI on average harvests the same amount, we see that it could generate $500M+ in fees annually at current rates. Of course, some of this would go down as LPs profitability would go down reducing their supply.
We arrive at a current valuation of 20 times annual earnings. However, trading volume is skyrocketing.
Top Centralized Exchanges are at 5-10x Uniswap volume. As trading and protocol (gas) fees go down, Uniswap can gather more volume.
As I explained above, DEXs have certain structural advantages over CEXs.
The long tail of assets and asset pairs is a place where CEXs cannot meaningfully compete. DEXs can rule this space and charge appropriately, with higher LP fees and higher token fee take rates.
Trading on DEXs is already more secure with no counter-party risks and for many people, it offers a simpler experience too. As more teams build out easy to use experiences, DEX volume will likely go up.
Key Risks
How much competition will there be? Uniswap has clearly been the most innovative DEX so far.
Will the Ethereum Blockchain be dominant, and if not can Uniswap successfully pivot? There’s no guarantee ETH will hold its DeFi dominance. Solana could win, Polygon’s L1 could come to hold most of the volume. However, Uniswap can hopefully pivot if they see signs that building on Ethereum L1 and Optimistic L2s is not enough.
The Fee Switch: When will it be turned on? Like any good start-up, UNI is focused on innovating and growing. Monetization can come later and the mechanism to do so is obvious.
Traditional Crypto Risks: Smart contract risks and hacks are always a big worry. However, the biggest protocols have the lowest probabilities of being hacked. After all, there’s billions of dollars worth of assets already being stored in Uniswap smart contracts. They’ve obtained several security audits and offered bug bounties.
I would love to hear your thoughts & suggestions.
You can find me on Twitter @AishvarR or reach out to me at raishvar@gmail.com.
This example does not take into account the liquidity provider fee which goes to the pool, and consequently increases K.
Uniswap also offers flash swaps whereby users can withdraw an arbitrary amount of tokens to do other actions on the blockchain. However, this is unlikely to be a material source of revenue relative to trading.
Note that this is actually a net positive, not negative. Previously, Uniswap v2 was structurally expensive and wasteful for providing liquidity on stablecoin pairs. e.g. Exchanging USDC for DAI always has nearly a 1:1 ratio. Curve, the main stablecoin DEX, was far more competitive, but Uniswap v3’s concentrated liquidity feature + lower fee tier have made it extremely competitive and gained the protocol net new volume.
Thank you for the fantastic and detailed post! I'm a bit confused by the tl;dr. It says the holders get 1/6. But you also mention the fee switch is turned off. So as of today, what do UNI holders get? If nothing, what's the incentive for holding UNI for those that are not interested in participating in governance (i.e. speculators)?
Great write up. Would be good to elaborate on the specifics of fee collection, including the denomination of fees collected (if swapping 100USDT for AAVE, is the fee collected in USDT?), and whether fees collected are then converted (e.g. to UNI) before moving to treasury.