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What is Uniswap and UNI?
Uniswap is the largest protocol for automated, decentralized token exchange, or simply DEX. A DEX represents a radical departure from the conventional centralized exchanges, often referred to as CEX, where an entity regulates and controls the users’ assets, which are put into the exchange’s wallet. This involves security and privacy risks. DEXs were conceptualized to overcome these problems, where users’ assets remain securely in users’ wallets until they decide otherwise. Users can then swap tokens directly without the need for an orderbook. In addition, CEXs tend to be selective and conservative, favoring well established cryptocurrencies. DEXs, on the other hand, accept smaller projects.
Uniswap was founded by Hayden Adams, a former mechanical engineer at Siemens, in 2018, mainly inspired by the technology that was first described by Ethereum co-founder, Vitalik Buterin in 2016.
UNI is the native Uniswap governance token, playing a central and multifaceted role in the protocol’s ecosystem. In addition to governance, UNI tokens can be used to pay for transaction fees on the platform, and they contribute to financing the development and growth of Uniswap.
UNI tokens were initially distributed through an air drop to individuals who had traded on Uniswap prior to September 2020.
Market capitalization of UNI is $3,1 billion and is ranked #37 on CoinGecko as of date.
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How does Uniswap work?
In order to understand how Uniswap works, we have to understand two essential concepts to DEXs: Liquidity pools and Automatic Market Makers (AMM).
- Liquidity pools are mechanisms that facilitate trading by providing a reserve of assets for buyers and sellers. These pools consist of pairs of tokens or assets, and users contribute their funds to them to facilitate trading. For example, if you try to exchange some Ethereum for altcoins, the trade can only take place if that particular amount of that particular crypto is actually stored in the exchange’s liquidity pool.
The assets that form a liquidity pool come from liquidity providers (LP). Anyone can become an LP for a pool by depositing an equivalent value of the two underlying tokens. When other liquidity providers add to an existing pool, they must deposit pair tokens proportional to the current price.
Whenever liquidity is deposited into a pool, unique tokens known as liquidity tokens are minted and sent to the provider’s address, in proportion to their contribution to the pool. These liquidity tokens track pro-rata LP shares of the total reserves and can be redeemed for the underlying assets at any time. These are just an accounting or bookkeeping tool to keep track of how much the liquidity providers are owed. If others subsequently add/withdraw coins, new liquidity tokens are minted/burned such that everyone’s relative share of the liquidity pool remains the same.
Liquidity providers are exposed to the risk of loss due to price divergence and market arbitrage, which is called impermanent loss (because it might revert if prices return to their initial value). Whenever a trade occurs, a 0.3% fee is charged to the transaction sender. This fee is distributed proportionally to all LPs in the pool upon completion of the trade.
To retrieve the underlying liquidity, plus any fees accrued, liquidity providers must “burn” their liquidity tokens, effectively exchanging them for their portion of the liquidity pool, plus the proportional fee allocation. The rewards come in the form of Uniswap native token UNI.
People choose to become liquidity providers in order to earn passive income in return for their contributions. The goal of this mechanism is to enhance the overall liquidity and efficiency of the platform.
Besides liquidity providers, later versions of Uniswap have introduced the concept of stakers through a staking infrastructure called “Unistaker”. This allows UNI holders to stake their UNI tokens, delegate governance voting power, and receive rewards. In this system, stakers cannot lose their UNI tokens due to slashing or market price movements, contrary to liquidity providers, because the tokens are not being used in trading pools or exposed to token pair volatility.
- AMM is a core component of decentralized exchanges. It is a smart contract based system that enables users to trade cryptocurrencies directly within liquidity pools without relying on traditional order books[1]. An AMM automatically sets exchange rates and connects the buyer and the seller in a deal.
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Use Cases of UNI Token
Use cases of the UNI token include the following:
- Governance
This is the primary use of UNI tokens. Token holders have the power to participate in the governance of Uniswap. They can propose and vote on changes, upgrades and improvements to the platform, as well as the use of the community treasury funds. Once a given proposal is ready for an on-chain vote, for UNI to be used in a vote it must be delegated before the voting period. A delegation can be made to another trusted address or to oneself.
- Transaction fees payment
- Community treasury, which can be used to finance the development of the Uniswap protocol as decided by UNI holders.
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Shariah Screening
In this section, we will highlight Shariah’s stance on some activities of the Uniswap ecosystem and subsequently attempt to draw Shariah’s opinion about the exchange and use of Uniswap token UNI. This screening is based on Uniswap’s documentation and GitHub documentation.
UNI’s Shariah compliance will depend on assessing the following elements:
- The project: purpose of Uniswap
- The legitimacy
- Does UNI token have value?
- Processes and Relationship between Uniswap partners
- Use cases of UNI
- The project: purpose of Uniswap
Uniswap has the goal of making crypto assets trading efficient, secure and low-cost, through decentralization and the automated market making described above. In this capacity, Uniswap’s general project does not conflict with Shariah.
- The legitimacy
Uniswap website provides detailed information about the network and the underlying processes and mechanisms. It is the largest DEX today, with the UNI token ranking no. 37 in terms of market cap. According to Certik Skynet, the platform security score as of date is 94.3, ranking no. 8, with an AAA rating. The platform goes under regular audits by trusted parties. The protocol is hence considered at high levels of legitimacy.
- Does UNI token have a value?
UNI token derives its value from its acceptance as a currency on the Uniswap ecosystem to pay transaction fees and rewards, having with the full features of currency therein. This relation is based on the force of Particular Custom العرف الخاص in Shariah. This means that the custom within that network has made UNI an acceptable currency that is subject to the rules of currencies in Shariah, the most important of which is spot delivery in case of exchange with another currency. The token having value implies that it can be used for value adding activities and exchanged for other value-based crypto and fiat currencies.
- Processes and Relationships
- Relationship between Uniswap and Traders
Traders submit their trading transactions on the Uniswap blockchain, where these transactions are implemented and recorded on the chain, in return for transaction fees. This relationship is an Ijara إجارة contract between the platform and the trader, where a service is provided in exchange for a pre-determined fee. The trading itself is permissible subject to currency trading rules in Shariah (Please refer to Litecoin report for more information about currency trading rules). No violation of the rules of currency trading has come to our attention. However, it falls upon the responsibility of the platform and the trader to avoid trading in prohibited crypto assets. Trading a prohibited crypto or violating the rules of currency trade will make the transaction void and payment of the related fees haram.
- Staking Process and Relevant Relationships
- Relationship between Uniswap and Liquidity Providers
The relationship between Uniswap and Liquidity Providers can be qualified as an Investment Agency contract (وكالة بالاستثمار), where the LP delegates to the platform the duty of trading the crypto assets they deposited and managing them in their pool, and in return both parties share the revenues collected from the transaction fees. In this setup, the investment is not risk-free, as it involves the risk of losing money due to price divergences and arbitrage. This makes this arrangement permissible, subject to the same conditions outlined in the previous section regarding the underlying crypto’s compliance with Shariah.
- Relationship between Uniswap and Stakers
The staking process, as described in section 2, involves locking UNI tokens and getting returns just for that, in a risk-free scheme. We believe this relationship is Shariah non-compliant due to its high resemblance to interest-based loan.
- Rewards
Rewards distributed on Uniswap are of two types:
- Rewards given to liquidity providers who deposit their assets in the liquidity pools. There is no concern about these rewards if they are traded crypto pair is halal.
- Rewards that are generated by staking UNI. These are deemed to breach Shariah rules, as previously noted.
- UNI Use cases
UNI token is used for the governance of the platform and for payment of trading transaction fees. Since the crypto assets world involves a lot of haram tokens, and Uniswap does not limit itself to Halal tokens, participating in the platform governance may raise a Shariah concern. In fact, there are a few tokens that currently constitute the majority of the trading volume on Uniswap. These include WETH, USDT, USDC, DAI, PROMPT, PIRATE, SPX, BADGER and a few others. Many or most of these tokens raise a Shariah concern. However, the governance process is related to the functionality of the platform and hence it is not a direct cause to trading prohibited tokens. the platform is open to all types of currencies, and it falls upon the responsibility of the user to use UNI only for halal purposes.
Regarding the staking process, we believe it yet has a minor volume among UNI uses.
Conclusion of Shariah Opinion
This report has analyzed UNI token based on the token’s structure, use cases, and the Uniswap platform’s operational framework and the reward mechanisms. The UNI token is the protocol’s native governance token, also used for transaction fees payment and rewards.
The report approves owning and exchanging the UNI token. Uniswap is a generic DEX, open for all crypto tokens. If hence falls upon the responsibility of traders to trade only in halal pairs of tokens. Shariah rules of currency trading must be met in all crypto currency exchanging transactions. No violations on this matter have come to our attention.
UNI is considered as currency, and thus it is also subject to currency trading rules.
The rewards distributed to liquidity providers from trading are deemed permissible.
However, the platform offers staking of UNI with guaranteed returns, which we deem Shariah non-compliant, and thus should be avoided. Participating in voting to support such a mechanism is not allowed. So far, there is no evidence that this activity is a major use of the token, but if it becomes so, this could affect the Shariah-compliance of exchanging UNI token.
This conclusion is subject to regular review, especially in relation to the aforementioned size of the staking activity.
[1] An order book is a dynamic list of buy and sell orders for a specific cryptocurrency, organized by price level.
