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Examining dYdX’s Journey to Profitable DeFi

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If you attended the Mainnet conference in New York last week and asked people to name the most admired companies in the cryptocurrency space, the majority would likely mention an exchange. On Wall Street, if you posed the same question about traditional finance, the answer would probably be a bank. Centralized exchanges hold a dominant position in the cryptocurrency industry in terms of profits, volume, stature, and innovation. However, their decentralized counterparts, known as DEXs, have also made significant contributions with innovations such as automated market makers (AMMs). Despite this, DEXs have not yet achieved the same level of recognition, user base, or profitability as centralized exchanges. dYdX, a perpetual-swap exchange, is one of the exceptions in terms of generating profits. However, it has not added a market pair since 2022, and its liquidity and listings are lagging behind major centralized derivatives exchanges. So, how does dYdX manage to stand out in the world of Web3 and decentralized finance (DeFi)? Let’s delve deeper into this topic.

Background: Perp-swaps and dYdX v3

The perpetual swap (perp-swap) is a derivative product invented by BitMEX, a popular cryptocurrency exchange. It functions similarly to a futures contract, but instead of having a maturity date, it pays out funding rates periodically, usually every eight hours. The introduction of perp-swaps propelled the rise of BitMEX in 2017 and played a pivotal role in attracting professional cryptocurrency traders. However, the early versions of perp-swaps also led to some systemic risks and flash crashes in the market. Another exchange, FTX, also gained traction with its perp-swap offerings, settling in dollars rather than bitcoin and listing a wide range of altcoins. In contrast, dYdX, as a DEX offering derivatives, was an early mover. In 2020, it introduced its first perp-swap offering, utilizing a centralized orderbook, matching engine, and Ethereum smart contracts for a noncustodial setup. While most DEX trading remains focused on spot trading venues, dYdX emerged as an exception.

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In 2021, thanks to two key developments, dYdX witnessed a significant increase in trading volume and market reach. First, it shifted from the Ethereum mainnet chain to layer-2 rollups built by Starkware, enabling faster and more cost-effective transactions. Second, dYdX launched its own governance and utility token, the dYdX token, which is used for rewards, governance, and security purposes. These changes formed the foundation for dYdX v3, allowing the platform to expand its trading volumes and increase the number of available market pairs from three to over 30. While dYdX has not introduced new market pairs or features since May 2022, it has managed to maintain a dominant position among derivatives DEXs.

Why Professional Traders Prefer dYdX v3

According to dYdX founder Antonio Juliano, around 80% of trading volume on the platform comes from institutional traders who interact via API, with the remaining 20% being “prosumers” who trade using the user interface. By “institutions,” Juliano refers to small hedge funds and proprietary trading desks rather than large asset managers or pension funds. These professional traders use dYdX for profit-making purposes, as opposed to learning or innovation. Transparency and security are among the key factors attracting institutional traders to dYdX. The use of Ethereum blockchain provides assurance against fund misuse, such as the pooling of exchange deposits with investment funds that led to the bankruptcy of other exchanges. In contrast, centralized exchanges often lack clarity regarding liability and fund allocation.

Regulatory arbitrage is another reason professional traders opt for dYdX. The most liquid cryptocurrency derivatives markets have historically been restricted in highly regulated jurisdictions. Even today, dYdX and Binance Futures do not offer their products to users in Canada or the United States. However, dYdX has managed to operate in several countries where Binance is not available. Additionally, dYdX’s Ethereum smart contracts provide protection against potential issues related to fund access and account restrictions, which are prevalent in centralized exchanges.

Cheaper trades also play a role in attracting professional traders to dYdX. In certain areas, dYdX fees are lower compared to centralized derivatives exchanges, making it more cost-effective for traders, especially when factoring in token rewards. While less liquid markets may experience slippage costs, dYdX’s liquidity is sufficient for most traders, with its ETH and BTC markets handling hundreds of millions of dollars in daily notional volume. In thinner markets, limit orders can help mitigate excessive slippage.

Changes in dYdX v4

dYdX v4, the upcoming version of the platform, introduces significant changes that could impact its future. The release will transition the exchange onto an appchain, which is an application-specific blockchain built using the Cosmos SDK. This transition enables three key developments: decentralization of the dYdX orderbook and matching engine, permissionless addition of new market pairs, and distribution of transaction fee revenue to token holders.

Permissionless Markets

dYdX v3 featured a team of developers who determined which market pairs to add to the exchange. However, dYdX v4 will introduce on-chain governance, allowing the community to decide which market pairs should be added or removed. This change enables faster addition of new pairs and provides opportunities to attract users from centralized competitors, as dYdX can be more agile in offering access to new coins and tokens that gain popularity in the market.

Fee Distributions

Similar to many cryptocurrency exchanges, dYdX uses both fees and rewards to incentivize users. Fees are charged for each trade, while rewards are given in the form of dYdX tokens, which function as loyalty points. It is crucial for exchanges to ensure that fees generated exceed the rewards paid out in the long run. In the past, dYdX experienced a net loss as it paid out more in rewards than it generated in revenue. However, a recent rewards cut has brought dYdX’s on-chain exchange operations into profitability. Moving forward, on-chain governance will determine the ratio between fees and rewards, with fee revenues being distributed to dYdX token holders. This approach has the potential to make dYdX highly lucrative and unique in the crypto market, as very few projects generate substantial revenue while growing.

Conclusion: The Need for Decentralization

dYdX’s transition to v4 and the introduction of new features are not just additive; they may be existential. Recent settlements by the U.S. Commodity Futures Trading Commission (CFTC) with derivatives exchanges operating without proper licenses and offering illegal leveraged products have highlighted the regulatory pressures faced by centralized exchanges. In response to this environment, a hybrid approach that combines elements of centralization and decentralization, like dYdX’s model, becomes appealing. As decentralized exchanges gain momentum, their ability to onboard users from any chain and offer pairs in any token poses a significant challenge to centralized exchanges. Those unwilling to embrace more complete decentralization may find themselves squeezed between highly regulated venues and fast-evolving DEXs. Ultimately, the path to success for decentralized finance lies in market infrastructure that functions as expected, maintains transparency, and adheres to clearly defined rules. With its upcoming v4 release, dYdX aims to position itself at the forefront of this innovation.

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