How Uniswap Represents a Paradigm Shift

A deep dive into the largest Automated Market Maker

Quick note: we’ll get back to analyzing the layer 1 blockchains with the next post. I’m jumping up a level to layer 2 here on Ethereum since Uniswap has been in the news with the recent SEC investigation. And because I find Uniswap to be one of the most fascinating financial assets I’ve ever analyzed. Let’s get into it.

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What is Uniswap?

Uniswap is a decentralized exchange built on top of Ethereum. This means that Uniswap is leveraging Ethereum’s base layer smart contract functionality. Sort of like how Google today leverages the base layer protocols of the internet like TCP/IP. The project was launched on November 2nd, 2018. Its governance token was released to the market on September 18, 2020. This is super important - Uniswap is currently being looked at by the SEC. The fact that they built a community prior to issuing a governance token is a critical fact. We get into that later in the report.

How does Uniswap work?

Traditional exchanges/brokers act as market makers. They sit in the middle of markets, matching buyers with sellers of financial assets. Today, centralized exchanges/brokers either charge fees for trades or do it for free, selling the order flow to large market makers and high-frequency traders. The latter is Robinhood’s business model. *And here is your quick reminder that when you use something for free on the internet, you are the product*. That’s the business model for centralized data networks. We can think of these as Google, Facebook, Instagram, etc in addition to services like Robinhood.

Uniswap does things a little differently.

It’s an open and permissionless data network. Anyone can access it. It’s free and open to all.

So how does that impact the marketplace/business model?

Because Uniswap is decentralized and permissionless, the network of users is individually provisioning supply (cryptoasset liquidity) into the protocol. Demand is coming from traders of assets. They can trade in/out of cryptoassets at rapid speed on Uniswap because of the superior-tech that blockchain represents (instant/final settlement). Traders love to trade crypto. Why? Because the market is super nascent. The asymmetry of information is wide. And data is very transparent in crypto. This opens up big opportunities for skilled traders. Furthermore, Uniswap is permissionless. Anyone can access it.

Quick Recap:

What I just described is the organic formation of a market by a set of global, distributed users. Demand is coming from individual traders all over the world. Supply is provisioned by individual liquidity providers all over the world — anyone can be a market maker. Everyone gets to access it. Everyone. And the traders pay fees to the liquidity providers as compensation for the service they provide. A positive-sum game. We can think of this as being akin to you or I getting paid to allow Google to sell our data.

Finally, all of this is possible because of the superior tech that underpins Uniswap in the form of Ethereum’s smart contract programming functionality.

Uniswaps Financials

Using Robert Greer’s super asset class framework, we can think of Uniswap as a capital asset. Capital assets in traditional finance refer to assets that produce a stream of cash. These include stocks, bonds, and real estate. Investors can draw assumptions around revenue growth, apply a discount rate, and calculate a present value based on the assumptions. Since Uniswap produces revenue, we can follow a similar valuation framework.

Uniswap has produced $1.1 billion in fee revenue over the last year¹. And to be clear, this is Uniswap’s first year producing revenue. They launched the project at the end of 2018 and slowly built it out. The market came to them as they scaled the functionality of the protocol. And once it was ready for the market to use, it produced $1.1b in the first 365 days. This averages out to about $3 million per day.

Can anyone show me a traditional company that has achieved these results in one year? You can’t.

I’ll remind you again: these revenues do not accrue to a central founding team or early investors. They are earned by individual users of the network that are supplying liquidity from all over the world.

We need to talk about the base layer of capital that those fees are earned from.

I’m talking about Total Value Locked. This is the total value of the liquidity in the system at any point in time, upon which the liquidity providers are earning the fees.

We can think of Total Value Locked (TVL) as we would the money we put into a bank account. We put the money there, and the bank then uses it to make loans and investments. They then pay us a small amount of interest [about .5%/year today😢].

Here’s the Total Value Locked over the last year:

I’ve run the numbers on this, and TVL averaged out for the year to be about $4.1 billion at any given time².

Now, we know that we produced $1.1 billion in revenue off of the TVL. So we can take the average of the TVL, $4.1b, and get an annual yield of 26.83% across the protocol.

Would you rather put your $ in the bank and earn .5% or cross the bridge and put it in crypto? You would earn 56x the return on the other side for stomaching the risk as an early adopter.

Comparing Uniswap to Robinhood

A few notes:

- Fully Diluted Market Cap: this is unknown for Robinhood. They can theoretically raise equity whenever the board of directors chooses. Uniswap has a predetermined monetary policy. There will only ever be 1,000,000,000 UNI tokens available³. Today, 61% are on the market. Market Value and Price/Sales are factoring in this known future dilution.

- User Growth: this is the average figure for Robinhood since 2015. Robinhood users grew 100-200% per year for the first 3 years, tailed off from 2018-2020, and then picked up again (largely due to crypto in 2021). Uniswap only has 1 year’s worth of user growth, since trading commenced about a year ago.

- Uniswap has about 30 employees. Robinhood has 3,213.

Takeaways:

- Robinhood has 7.2x the number of users as Uniswap yet loses $1.3 billion/year right now. Uniswap makes $1.1 billion.

- Uniswap has essentially zero marginal cost for adding users. This is because they leverage Ethereum for security/functionality.

- Robinhood can already see the future. They are looking to tap into Uniswap to provide access for their customers to the liquidity on Uniswap⁴.

- When a centralized incumbent is disrupted by an open protocol with clearly greater functionality, VCs typically project a 10x value add from the incumbent. Based on the above analysis, this would mean that Uniswap is potentially underpriced by 17x today vs Robinhood. We could also compare Uniswap against Coinbase, Kraken, etc. (please do your own research).

Launch Story

Uniswap was founded by Hayden Adams. When Vitalik Buterin, the founder of Ethereum, proposed an Automatic Market Maker protocol in a paper he wrote in June of 2017, Hayden, who had just left his engineering job, immediately went to work.

The protocol went live less than a year and a half later. The rest is history.

The most important aspect of Uniswap’s launch is the way in which they built a community and later launched their governance token.

The key here is that Uniswap built a community for two years before launching their token. They never raised any $ during this process.

It was only after the network was fully functioning that the team released their governance token. This token represents direct voting rights when it comes to the future development and direction of Uniswap. When the token was launched, the founding team effectively stepped away from direct control. Uniswap is now wholly owned and managed by the holders of the governance token.

This effectively skirts securities laws⁵ which state that for an asset to be a security, the recipient of the asset must be making an investment that relies on the effort of others.

I mention this because the SEC is currently “investigating” Uniswap. Apparently, they have been looking at Uniswaps marketing. It seems the SEC is simply sniffing around and trying to figure out how all of this works.

Takeaway: Uniswap clearly had some savvy investors/advisors/lawyers when they launched the protocol. It appears they may have skirted security laws but we’ll need to continue to monitor the situation as things progress.

Investors & Advisors

Prior to launching their governance token, Uniswap raised $11m in a Series A round. They are backed by notable and reputable Silicon Valley firms such as Andreesen Horowitz, USV, Paradigm, Version One, Parafi Capital, SV Angel, and A. Capital. Once the equity was raised, the token was released to the public. Below is the initial distribution:

- 60% to the community (15% was gifted to early users of the protocol. Now worth $8k/user)

- 21.51% to the founding team and future employees with 4 year vesting period

- 17.8% to equity investors with a 4 year vesting period

- .069% to advisors with a 4 year vesting period

This allocation of tokens to VC investors may be surprising to you. Let’s discuss.

We can view Uniswap’s governance token launch as their “going public” moment. In this case, the public gets to invest in a HIGH growth tech protocol at the series A stage.

Were retail investors allowed to invest in Google, FB, Amazon, Instagram, etc etc etc at the series A stage? Hell no they weren’t.

Those companies raised several rounds of equity before going public. Retail investors got the scraps after 5-6 rounds of value had already been extracted by early investors.

This is a big deal. You may be surprised that Uniswap has VC backing and advisors. But in my opinion, the structure here looks pretty good. In fact, I would say that this appears to represent a paradigm shift in terms of how we could see companies raise capital, grow, and govern themselves in a decentralized format going forward. [As a quick aside: this is why I always say that Bitcoin is the only truly decentralized cryptoasset.] Most projects built on Ethereum (including Ethereum itself) have a similar structure.

Furthermore, Uniswap’s treasury is currently worth $9.6 billion⁶. I’ll repeat Uniswap treasury is currently worth $9.6 billion. Can you name any companies that have been around for essentially one year and have a balance sheet like that?

The holders of the UNI token will have direct control over these funds which can be spent on grants, marketing, protocol enhancements, security audits, and potentially as future dividend payments to holders of the token.

Tokenomics

- Fixed supply of 1,000,000,000 UNI tokens with 63% currently on the market.

- The remaining tokens will come to market via “liquidity mining” and other incentive programs. This is a form of yield farming in which users earn an additional token [in addition to the fees earned] for providing liquidity. Liquidity mining will be turned on when the community determines it is the right time to do so.

Risks

- There is risk in providing liquidity into these protocols. It comes in the form of “impermanant loss”. This can happen when one of the assets in a trading pool experiences volatility against the other asset. I highly recommend folks learn about this before adding liquidity to any of these protocols. There have been cases where the fees earned do not make up for the loss. In these instances, users would be better off simply holding the asset than provisioning liquidity into the protocol.

- Security vulnerabilities. We haven’t seen any major issues with Uniswap but due to the nascent nature of many of these protocols, we have to consider these risks as early adopters. On a larger scale, Uniswap has outsourced most of its security expense to Ethereum on the base layer. If Ethereum were to have a major issue, Uniswap could be impacted.

- Competition: Today Uniswap has 57% of the transaction volume within the decentralized exchange marketplace. Its closest competitor, Sushiswap controls 18%. Curve is next with 9%. These markets are free and open. Expect intense competition.

- Regulatory: In the near term we may experience increased regulatory heat on Uniswap and other decentralized exchanges. The primary concern for the SEC is AML/KYC as well as identifying securities that may be trading on the platform. They would like to be able to identify who is using Uniswap so that they can ensure users are paying taxes, and not laundering money. It’s tricky because regulators are trying to protect retail investors, but when they do this, they oftentimes block retail from access. The point of these networks and blockchains is that they are permissionless. 2 billion people are still unbanked worldwide. Blockchains solve this. We need regulators to understand this and adjust the laws to accommodate this powerful new innovation.

- Distributed Governance: this is a new and untested idea that we’ll have to see play out in real-time. There are early concerns around a small set of users controlling a large % of votes. We should expect some challenges here.

Conclusion

I think we can all see that Uniswap is an incredibly unique protocol and asset. The rapid early growth of Uniswap represents its undeniable utility in the ecosystem. Today we mostly see trading of speculative cryptoassets on the exchange. However, we should anticipate that a protocol like Uniswap could also be used for the trading of real assets in the future. I’m talking about tokenized real estate, bonds, and stocks.

The fact that Uniswap can scale users at almost zero marginal costs is something that is difficult for the average investor to fully grasp. This is representative of the power of the technology underpinning the protocol. Open protocols collapse and compress the cost of existing tech. We see that in spades with Uniswap.

The decentralized nature of its governance makes it even more interesting. I believe we may be witnessing the early stages of a potential disruption to not only how companies are financed, but how they are run. We are potentially altering the corporate business model in the long run here.

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Thanks for reading and for your support. Up next we’ll get back to analyzing the large layer 1 blockchains (Bitcoin & Ethereum). From there we’ll move our way through the tech stack so that you can get a clear picture of where we stand today and where we may be heading.

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And stay curious my friends.

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Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general investment information only, is not individualized, and as such does not constitute investment advice.

1. tokenterminal.xyz

2. tokenterminal.xyz

3. coinmarketcap.com

4. https://ipfs.kleros.io/ipfs/QmR5e9kfxMjuDAUGgqam1Njpe9qo1CN35mVLkUCiU1PkKA

5. https://www.ar.ca/blog/are-uni-tokens-subject-to-securities-enforcement-action-by-the-sec

6. open-orgs.info