dYdX

DACM Special Situations Snapshot

10 min readDec 1, 2022

Summary

dYdX is the dominant decentralised derivatives platform having created an on-chain trading experience orders of magnitude better than its’ competitors;
Growth, both dYdX-specific and across DEXes as a whole, is accelerating post FTX’s demise with dYdX’s latest epoch showing triple-digit volume, OI and fee growth;
dYdX V4 is under development and will see the platform move to its own, Cosmos SDK chain allowing for a fully decentralised, off-chain orderbook and matching engine;
With dYdX V4 the DYDX token potentially gains materially improved economic value with links to the total value locked on the blockchain and future MEV generated — preliminary DACM estimates suggest this MEV contribution could be material;
Potential catalysts are growing DEX market share of total trading post-FTX’s implosion, the launch of dYdX V4 and the associated likely tokenomic improvements; and
Concerns are the technology risk around launching the new platform, the anaemic state of crypto trading markets as well as a significant uptick in token supply over the next 12 months.

dYdX to Date

If you are an institution looking to trade derivatives in a decentralised way (surely post FTX we don’t need to tell you why that is important), dYdX is the dominant platform. While we now take it for granted, dYdX was able to create an on-chain trading experience orders of magnitude better than its’ competitors and push forward crypto-native market infrastructure.

Founded by Antonio Juliano, previously an engineer at Coinbase (and briefly a Bitcoin maxi), in July 2017 — dYdX was a logical next step following the rise of spot decentralised exchanges such as 0x and Kyber. Margin trading and derivatives were beginning to enter the fray, namely on Bitfinex, and Antonio had the foresight to begin building a decentralised alternative.

April 2020 marked a key point in dYdX’s history when it began offering Perpetuals. This mechanism created by Arthur Hayes and company at BitMEX, quickly became the most traded product in all of crypto. As a result, by early 2020, dYdX was the #1 DEX by volume, approaching close to 50% of DEX market share (at a what now looks meagre; $10m of volume per day).

DeFi summer created new problems for dYdX — there were too many traders on Ethereum. Gas fees made the user-experience untenable and as a result the team was beginning to subsidize users’ costs. With a single trade costing >$100 in gas, it was unrealistic to make a profit from trading fees.

And so began the shift to Starkware’s Layer 2 solution. dYdX is now able to offer a trading experience comparable to its centralised peers, with low fees, fast withdrawals, and cross-margining as well as unprecedented asset visibility. The exchange’s growth since has been staggering — it averages close to $1bn of volume per day, has done >$760bn in cumulative volume, and has had >91,000 total users since 25 Feb 2021. dYdX is now by far the largest player in the decentralised derivatives space, the closest competitor is GMX which averages $5–10bn of volume per month (vs dYdX’s $15–30bn). A full peer comparison is shown below:

Post-FTX, the protocol looks to be at a new inflection point. Epoch 16 (Oct 25 — Nov 22) revealed impressed month-on-month (MoM) statistics. Trading volume increased by 110% and ‘Ending Open Interest’ grew by a massive 2,664% closing at $6.7b. The userbase grew significantly as well, there were 6,462 unique depositors (+157%) and 14,359 active traders (+37.2%). In total this resulted in total-epoch protocol fees of $7.88m (+122.9%). Trading rewards and liquidity provider rewards totalled 4,027,397 DYDX (c.$7.25m), meaning the protocol is close to break-even. Strong results in a cyclically very weak market.

Quick Token Economics

Initially released to the community via one of the largest airdrops in crypto, the DYDX token is a protocol governance token with additional utility in the form of fee discounts and opt-in staking.

The safety staking module (‘SSM’) gives DYDX holders the opportunity to stake their tokens (‘stkDYDX’) in return for insuring the protocol from black swan tier events. Mechanically, if the protocol suffers from a shortfall event, the tokens staked in the SSM will be slashed (and resold) to make users whole again. In return, stakers earn a yield (in new DYDX tokens) based on their pro-rata ownership of the pool. As it stands this equates to a c.12.5% yield on stkDYDX. This is funded through token emissions with 2.5% of DYDX dedicated to incentives, however, as these run out it could make sense to funnel a proportion of revenue to stakers. Xenophon Labs has produced great research on the efficacy of this mechanism and has made the suggestion to wind it down — arguing that this is a poor use of tokens and creating unnecessary sell pressure.

dYdX’s lowest fee tier is currently a 0.020% maker fee and a 0.050% taker fee. This can be offset by up to 50% depending on the number of tokens owned by traders. It would require 5,000,000 tokens to reach the full 50% discount — requiring a lot of trading to make this an obvious decision.

In terms of token performance, we think it is fair to say DYDX has suffered from its emissions profile — creating persistent sell pressure. 250,000,000 DYDX (25% of token supply) was initially allocated to trading rewards, which recently was reduced by 25% in DIP 16. In effect this means that 2,876,712 DYDX (c.$5.5–6.0m at current prices) is emitted to traders, without lockup, every 28 days. Given the profile of the recipients (trader), the majority of these rewards will likely have been and continue to be sold on the open market.

This is not without some benefits. dYdX has done a great job of using its token to build a brand and user base and they have continued to experiment with tokenomics. Now with dYdX v4, or the more aptly named dYdX Chain, the team is entirely altering the dynamics of the DYDX token.

dYdX V4

dYdX V4 will be developed as a standalone blockchain based on the Cosmos SDK and Tendermint Proof-of-stake consensus protocol, featuring a fully decentralised off-chain orderbook and matching engine.

Before looking at dYdX more specifically, it makes sense to review Cosmos and consider why dYdX has chosen to adopt its technology. DACM wrote about the ecosystem broadly in our Osmosis research piece, but we will recap the core Cosmos thesis:

The Cosmos universe is premised on the classical economic principles of trade specialisation and differentiation, as well as a priority of chain sovereignty. Billing itself as the “Internet of Blockchains” Cosmos has a key mandate to make seamless communication between every blockchain in existence possible. More practically, Cosmos is a decentralised network of independent and parallel blockchains, powered by an open source technology stack consisting of BFT consensus algorithms such as Tendermint’s PoS and PoA Consensus, Cosmos’ SDK development kit and the IBC Protocol.

The rationale behind IBC is that in order to support the transaction throughput, application diversity, cost efficiency, and fault tolerance required to facilitate wide deployment of distributed ledger applications, execution and storage must be split across many independent ledgers which can run concurrently, upgrade independently, and each specialise in different ways.

And so with decentralisation and specialisation in mind, dYdX has decided to create its own Cosmos ‘AppChain’. The dYdX team realised that a key benefit of developing its own blockchain is the ability to exercise complete control over the blockchain mechanics and tasks that validators perform. This has major implications for both the product and DYDX token. An example of a UX improvement possible is the ability to abstract away gas fees and only charge trading fees akin to a centralised exchange, which is then returned to validators and their stakers.

The role of a validator in dYdX v4 will likely not look like many other blockchains, and we expect a significant number of ‘unusual’ operators will step in to fill this role i.e., market makers. To quote the dYdX Chain announcement post:

”In dYdX V4, each validator will run an in-memory orderbook that is never committed to consensus (i.e., off-chain). Orders placed and cancellations will be propagated through the network similar to normal blockchain transactions, ensuring that orders placed and cancellations will always make their way through the network. The orderbook that each validator stores is eventually consistent with one another. On a real time basis, orders will be matched together by the network. The resulting trades are then committed on-chain each block.”

Through this design, the DYDX token gains a use case additional to governance. The token will be used for staking to validators, securing the protocol (in a more direct way than the current safety module). In effect this means that the value of the DYDX token will have a link to the total value locked on the blockchain, to protect against consensus attacks — additional to the trading fees received. Furthermore, if market makers are to become validators, then we would expect maximal extractable value (‘MEV’) on the dYdX chain to become a battlefield.

MEV on dYdX Chain

Anything said in this section is going to be speculative as details are not yet known. However, given the intense discourse around MEV throughout the crypto ecosystem, we believe it’s important to think through the implications of MEV on dYdX chain and the role it may play in value accrual. And we are not the only ones thinking like this:

MEV Explore by Flashbots suggests that there has been >$600m of MEV extracted on Ethereum mainnet alone — and this is likely just scratching the surface. Once you include long-tail MEV, L2 MEV, and non-EVM MEV, it is plausibly a figure in the low billions. It is therefore significant that the MEV produced by dYdX traders across >$760bn of volume is going to be steered towards dYdX Chain validators (as opposed to Starkware sequencers).

It would make sense for those experienced in capturing MEV to become validators, as they will have access to the mempool and have the right to produce/reorganise blocks. (note that MEV extraction has historically been more primitive on Cosmos due to the first come first serve nature of the mempool, which incentivises spam, but we expect this to become more advanced as projects like Skip Protocol continue to build, and more formalized blockspace markets are created).

Again, this is not all meant to be negative. MEV accruing to dYdX validators can be considered an extension of the security budget, making the chain and its users more secure. Additionally, yield from MEV should at least partially accrue to DYDX token holders that participate in staking (not just the validator/MEV searcher itself).

To attempt to quantify the size of this opportunity (which should be seen as an illustration only), we can refer to the Flashbots MEV data for Uniswap v2 and v3, alongside Uniswap’s self-published volumes. If dYdX searchers could extract a similar amount of MEV as Uniswap’s then there has been c.$285m of uncaptured MEV for validators (working below). It is again worth noting that this is highly speculative, and it’s not obvious that the MEV dynamics between Uniswap and dYdX will be the same, but directionally this looks to be interesting.

Overall, the redirection of MEV enabled by the move to an AppChain looks to be a key catalyst for DYDX — and raises the question of will other dApps take this route? Instead of paying MEV as rent, it could be recaptured by the protocol and the users who create it. This further increases the design space for protocols, for example, dYdX could choose to remove all trading fees to increase volumes, and instead profit from increased MEV capture. This is not a suggestion that all dApps make the move, but we expect this to become an increasingly large point of contention and a key decision in their roadmaps.

Potential Catalysts

Tokenomics changes reframe the DYDX token from largely a governance token to a potential ‘MEV token’ that could lead to real revenue.
Potential re-rating from the market growth of decentralised exchanges post-FTX as users place a higher value on the importance of transparency and self-custody.
dYdX is an early-mover to adopt its own ‘AppChain’ giving it more ownership of its tech stack/user experience and providing new future potential growth areas as well as control over its own mempool.

Key Concerns

Technical risk in the form of building a novel orderbook mechanism, one example could be the communication overhead between validators to create a ‘shared’ orderbook experience.
Users may not wish to bridge to the dYdX chain, instead preferring the Starkware experience, this could put pressure on liquidity and customer retention.
General fall in volumes across the market as activity drops and market saturation for decentralised derivatives is already high, with more competitors in the pipeline, it will be tough for dYdX to retain its existing market share.
Aggressive vesting/token supply schedule over the next 12 months.

Conclusion

dYdX has grown to be a core piece of the existing DeFi infrastructure and is undergoing substantial change. When a project moves from loss to potentially a profit, we believe that can see a material change in investor sentiment and the universe of potential investors. dYdX’s decision to move towards its own chain has potential to do something similar. Not only an impressive technical feat (there is still execution risk here to be clear), dYdX V4’s MEV implications could allow the protocol to return cashflow back to the tokenholders in the future.

DACM’s funds and funds advised by DACM are investors in dYdX. This DACM Special Situations Snapshot is for general information purposes only and is not intended to be investment advice in any way.