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Uniswap was created by Hayden Adams with funding from the Ethereum Foundation to fund development and audit before launch. The first version of Uniswap was launched on the last day of the Devcon 4 conference, and the initial liquidity of 3 tokens was only worth $30,000. It quickly gained market attention and received initial seed investment, enabling the team to work hard to improve the agreement and launch a second version.
The main new feature of Uniswap V2 is the ERC20/ERC20 liquidity pool. Uniswap does not use the traditional order book model, but aggregates the tokens into smart contracts, and users conduct transactions against these liquidity pools. Anyone can exchange tokens, add tokens to the pool to earn fees, or list currencies on Uniswap.
Uniswap does not use the order book for price discovery, that is, the price of the asset is derived from the intersection between the highest buying price and the lowest selling price. Instead, it uses the smart contract of the exchange to aggregate tokens and determine the price.
For example, if you want to trade DAI with ETH, ETH is sent to the pool of the contract, and DAI is sent to you. No need to wait for the order book to match, because you trade directly with smart contracts. The amount of DAI you get is based on the automatic market maker formula-based on the ratio of ETH to DAI in the pool.
People adjust the pool to maintain its ratio to other market prices. Suppose the pool is out of balance. For example, the current market price of 1 ETH is 100 DAI, but 1 ETH in the pool can get 200 DAI. The market maker does not hesitate to put more ETH in the pool to withdraw DAI, and then sell it on another exchange for profit. Soon, this trading activity will rebalance the pool. This is an extreme example, but it helps illustrate how liquidity pools retain market prices.
Anyone can add liquidity to the pool. When liquidity providers add to an established pool, they should add two tokens in proportion, otherwise the liquidity they add is at risk of being adjusted. This logic contributes to the deep growth of the pool while maintaining price stability. Larger liquidity pools are beneficial because they allow greater exchange to occur without distorting the ratio of the pools. Uniswap rewards providers with fees collected by the agreement and incentivizes users to increase liquidity.