Intro

The crypto market is huge, and constantly growing (not up only, but over time).

DeFi use is exploding.

The derivatives market is the largest financial market in the world.

dYdX captures a bit of each of these incredibly powerful markets.

It intends to become the biggest crypto exchange in the world, centralised or decentralised.

Can it succeed? Let’s find out…

Disclaimer: This is not investment nor investment advice. Only you are responsible for any capital-related decisions you make and only you are accountable for the results.

TD:LR

• dYdX is bigger than Coinbase and growing exponentially.
• It has a hall of fame list of investors, boasting the likes of Andreessen Horowitz and Paradigm.
• It’s the biggest, most liquid and most advanced DeFi derivatives exchange, able to compete directly with the likes of FTX and Binance.
• The question is, can it overthrow the centralised rulers, or is there pain in store?

What is dYdX?

dYdX is a decentralised perpetual futures (perps) exchange, built on StarkWare’s StarkEx blockchain, which offers up to 20x leverage.

If you’re not sure what perps are, check out our futures article. Most are familiar with them as the leveraged positions you take on FTX and Binance.

Check out this introduction to dYdX video posted in Feb 2021:

[embed]https://youtu.be/PGE1uoiZTmM[/embed]

Currently, there are 36 markets live on dYdX, with this number increasing rapidly (up from 3 in March 2021). Where there is liquidity and demand, more markets will be added.

The protocol is sitting head and shoulders above the rest of the DeFi market, and has managed to come into direct competition with the likes of Binance and FTX. The question now is, can they continue to grow and take market share from the centralised exchanges (CEXs)?

History of dYdX

dYdX was the first decentralised exchange to move away from the Automatic Market Maker (AMM) model, which suffers from liquidity issues causing high slippage for users (meaning higher costs), latency and flash crashes (during high volatility).

For spot DEXs, the AMM style is hugely beneficial, but for futures, it is widely considered sub-optimal. dYdX instead used an orderbook to make their markets (where large parties provide liquidity to the markets). This was a game-changer, and a major factor in the exponential growth of dYdX (as seen below).

As the only perp exchange utilising ZK roll-ups (viewed by many, including Vitalik, as the future), and with a hall-of-fame list of backers, you certainly can’t ignore dYdX.

Biggest than Coinbase?!

On September 27th and 28th 2021, dYdX recorded $18.6bn in transactions, compared with $5.9bn for Coinbase (according to CoinGecko). Derivatives are already larger than spot markets in crypto, and the CeFi to DeFi gap is getting ever smaller, especially with DeFi apps like dYdX near perfecting the user experience.

It seems like only a matter of time until we see the DeFi snatch market share from CeFi – could this become the flippening that defines the crypto markets?

The DYDX Chain

dYdX is currently on StarkEx, an exchange specific layer 2 blockchain by StarkWare. This is set to change after their recent announcement, they are building their own blockchain, the dYdX chain, on the Cosmos SDK.

dYdX state they have a pure product first approach, and have no loyalties to any chains.

V3, on StarkEx, has a centralised order book and order matching engine. Going in to v4, they want to ensure they are fully decentralised, and “a decentralised system or protocol is only as good as the least decentralised component of that system”.

StarkWare’s, and other layer 2s, blockchains have centralised sequencers (essentially centralised block production) at the moment, which would mean if DYDX launched v4 on StarkEx it wouldn’t be fully decentralised.

L2s plan on decentralising sequencers, but this is a very difficult problem to solve, and could take a lot of time to do. DYDX care about building the best product possible now, and the time it will take for L2s to fully decentralise could be too long to satisfy this.

Even Antonio, dYdX's founder, states that this is a very risky decision. They don't know if they can build the best possible product on a Cosmos app chain, but “pretty much everything except this had been done before by somebody that was pretty good. This was a new approach, and has the potential to be the next 10x technology.” Also stating that if they are wrong, they aren’t too proud to simply go back to StarkWare or the best option at that time.

There are other reasons, apart from decentralisation. Currently, no blockchain can handle the amount of transactions needed for the order book and matching engine. So dYdX are building a separate, decentralised network for those. This network doesn’t have to come to a consensus (each validator stores their own order book), as it’s only for the order book and matching engine, which makes this scalable enough to deal with the throughput needed. Having it all on Cosmos SDK makes this much easier.

Another potential upsides of the dYdX chain, for example, if the community votes for the DYDX token to be used for gas fees, that will dramatically increase the token utility and value proposition.

You will be able to use Metamask or any other wallet, but they have to rebuild the wallet interface, in a similar way to what they did for v3 - essentially they built a wallet into their product, so using the DYDX chain will be entirely within the dYdX website/app, with bridging and wallet all internal and fluid. Essentially you would just click deposit in the same way as you do for a centralised exchange (except no FIAT on-ramp, at least yet).

Risks

Of course, there are trade off's. They lose the security of the Ethereum blockchain, and are moving to an extremely experimental model as the first to create an app specific chain on anything like this scale.

There are risks with technology, such as bridging. As dYdX is a derivatives exchange, rather than spot, you only need 1 collateral token, not every asset on the exchange. This makes bridging much easier. They are in talks with Circle to get a native USDC token which would act as the collateral.

This move may cause inflation, as it would likely be needed to pay validators and stakers. There are a lot of questions around this, such as what inflation rate, how much will stakers and validators receive, and more, which haven’t yet be addressed, but likely they will just copy the best models from other layer 1 blockchains.

Future of the dYdX Chain

dYdX are committed to open-sourcing the DYDX chain code by the end of this year (2022). This could mark a huge step in app-specific blockchain development, as if it is successful, others could simply copy and amend the code that dYdX used.

As more information come out around the dYdX chain, we will continue to update our community.

Team

The dYdX team is outstanding. Largely made up of Princeton graduates, the team boasts former employees of Coinbase, Uber, Facebook, Goldman, Bridgewater, Google and Bloomberg (and that’s just the senior management).

Investors

With a hall-of-fame list of investors, as seen below, dYdX is certainly doing something right in the eyes of the big boys.

Trading on dYdX

For a massive range of analytics and metrics on dYdX check out this dashboard.

Rather than going into depth on the trading experience and offering of dYdX, I’m going to outline the key characteristics.

If you want to give it a go without risking your hard-earned money, check out their testnet (although note this may not be operating the latest version).

dYdX has 36 assets available and very liquid markets, add to this the on par, even arguable better trading experience than the centralised counterparts, as well as a mobile app, order types including limit and take profit (and more), no gas fees for trading, pricing based off major exchanges (meaning pricing parity with CEXs), and great trading rewards and competitions, and you have a recipe for success.

This has been reflected in dYdX’s performance, with it regularly achieving over $1bn daily volume, spiking as high as $15.4bn on Feb 15th 2022.

Trading Rewards

Trading rewards are a big driver of volume for dYdX at the moment, with 25% of the token supply dedicated to them. This opens an avenue for exploitation, as we see regularly in crypto, reward structures can be gamed. There is potential for market makers to provide liquidity to the dYdX orderbook, then trade against their own liquidity whilst simultaneously hedging their risk, allowing them to take advantage of the DYDX trading rewards up for grabs. The spikes seen in the chart in the reward window backs up this theory, or at least demonstrates that the rewards are causing unnatural spikes in volume on the platform.

Trading Leagues

An initiative designed to attract new users, and keep current users trading, the leagues gamify trading on the platform with some huge prizes up for grabs. Announced in January, the leagues are an innovative competition that works in a similar structure to football leagues, where traders can be relegated or promoted through the leagues. The higher the league, the higher the prizes.

They run in weekly ‘seasons’, incentivising traders to continue trading every week, especially if they are in a high league (so they don’t get relegated and miss out on prizes).

Funding Rate, Margin and Leverage

For information on the funding rate, margin and liquidation check out our crypto school article which covers all three. For the purpose of this article, I’m going to assume you either know what they are, or have read the article.

dYdX’s takes funding payments every hour, and requires a minimum of 4% margin collateral (for BTC and ETH, which have higher maximum leverage than other assets, which have an 8% minimum).

Collateral

Collateral for the platform is USDC, and is cross-margined, meaning you use the same USDC collateral for any position on any asset across the platform.

This is in contrast to when the protocol first launched, where you had to hold the native asset for each position as collateral (e.g., if you had SOL, ETH and BTC longed, you would have to hold each asset in your dYdX account as margin).

This was clearly sub-par to CEXs and had to change. The move from layer-1 Ethereum onto layer-2 StarkEx is what allowed this change, facilitating much better liquidity and many more markets (there was only 3 using the old system).

Mobile App

One key competitive advantage dYdX has is their new mobile app, which was released to the public on 10th May 2022, check out the announcement and video below to see how it works.

[embed]https://youtu.be/7BOA6cZdzHU[/embed]

dYdX is one of the first DeFi protocols to launch a mobile app, and by far the largest. A vital tool, it differentiates them from their competitors within DeFi, and further brings them into direct competition with the top CEXs.

dYdX Airdrop

[embed]https://youtu.be/ShddM8IiiG0[/embed]

dYdX airdropped tokens to early users of the protocol, with the snapshot ending at 0:00 UTC on 26th July 2021. A massive 75,000,000 DYDX tokens were distributed to around 64,000 users. This was distributed according to a tiered system, which you can see below.

Note, the airdrop was not distributed to US users or residents.

The airdrop proved a massive success, with dYdX activity relative to centralised exchanges rising from a few basis points to single digits immediately after the airdrop. You can see the rapid growth after the airdrop release on 7th September 2021 in the chart below.

Some lucky traders received over $50,000 in DYDX!

Distribution and Tokenomics

The DYDX token airdrop amounted to around 7.5% of the total supply, so what is happening with the rest? See the distribution of tokens (when fully unlocked) below.

There is the option for governance to vote in an up to 2% annual inflation rate after the supply of 1,000,000 is reached in August 2026. Whether this is done, and what it will be used for, is in the hands of DYDX holders.

The circulating supply sits at around 100m (23/05/22), or 10% of the total supply. Each month, 3,835,616 DYDX, or around 3.8% of the current circulating supply, is distributed as trading rewards. This is alongside 1,150,685 DYDX, or around 1.1% of circulating supply, which acts as liquidity provider returns.

Investor tokens begin unlocking in Feb 2023, with 30% unlocked at that time, 40% unlocked evenly between March and August 2023, 20% evenly between September 2023 and August 2024, and the remaining 10% between Sept 2024 and Sept 2025.

The result of the above distributions can be seen on the graph below, showing when DYDX tokens will unlock starting from September 2021.

This is a scary chart, especially around Feb 2023, when we see the circulating supply almost double overnight (with a 15% of total supply unlock for team and investors). However, when looking at projects with steep inflation, we must consider the fully diluted value.

Market Cap and Fully Diluted Value (FDV)

At the time of writing (23/05/22) dYdX has a market cap of $223m and an FDV of $2.2bn.

It has $960m total value locked, with annualised revenue of over $320m.

Consider this. Decentralisation is supposedly coming by the end of this year. With that, the ability for token holders to vote for revenue sharing. Should this happen, and 80% of revenues are then distributed to token holders (this is a high percentage, it may well be less due to operating costs, however as an example I’m using 80%), that would be $256m going to token holders. More than the entire current market cap of the protocol!

To put this into perspective, dYdX can be viewed as a relatively similar style investment as Tesla (high growth, huge potential, long way to go before full vision is realised but making good progress). dYdX is currently trading at 0.87x price to earnings (the yearly revenue vs market cap, also known as the PE ratio). Tesla is trading at over 80x PE!

Note, there are many differences, Tesla was chosen as it is an extreme example of a high price to earnings (PE) stock (there are others, with Twitter over 140x PE and Amazon 55x PE). Tesla faces very different circumstances to dYdX, so this should not be taken to represent dYdX’s potential valuation in anyway, it is only to demonstrate that it is currently trading at a low PE ratio.

On the other side of the scale you have Coinbase, which is currently trading at only 7.7 PE, likely due to the bearish sentiment on crypto amongst traditional investors at the moment.

Even at its fully diluted value, dYdX is only trading at 10x price to earnings. dYdX has huge growth potential, due to the migration from CeFi to DeFi, the incredibly refined user experience, and the growth of the crypto market as a whole. Add to this their massive first mover advantage and network effects, and you see that a comparison to Coinbase doesn’t do it justice (and many consider Coinbase to be undervalued at the moment, with Ark Invest buying $30m in COIN shares recently).

In short, whilst the inflation rate may have short term price impacts, as early investors book profits after getting involved at a $10m valuation and over 200x’ing their initial investment (at current prices), in the longer term, it is of little concern as long as dYdX continues to perform.

V4 & Full Decentralisation

At the moment dYdX functions as a hybrid exchange, with the bulk decentralised, but some components remaining centralised. V3 (the current version) handles trade settlement and liquidations with a centralised orderbook and matching engine. All fees collected go to the centralised entity as profits.

Initially, dYdX had no intentions of fully decentralising. They didn’t believe it was possible with the current technology and were concerned it would compromise their offering.

Happily, that doesn’t seem to be the case. dYdX intends to be fully decentralised by the end of 2022!

With release of V4, expected by the end of 2022, the V3 API will stop being used, and instead, a fully decentralised perpetual contracts market API will ship, seeing a fully decentralised dYdX born.

This will be where dYdX can move from being on par with centralised exchanges to better.

Why, you ask?

Simple: revenue sharing, censorship resistance, and community ownership & decision making.

This is something no centralised exchange could ever effectively implement, and to be honest, they wouldn’t want to. Why would they, when they can just keep the money and decision making.

As the protocol will be community-governed, the community could easily put forward a proposal to share revenue with token holders. Remember that example in the ‘market cap & fully diluted value section’ above…

The potential of revenue sharing means dYdX holders will essentially own shares in the ‘company’, and these shares could give them a pro-rata proportion of the revenue.

The censorship resistance means there is no culprit for regulators to be hostile towards. Once fully decentralised, the DYDX holders are responsible for ensuring that governance decisions are made in compliance with applicable laws and regulations. What this means, is that if a government suddenly decides to ban dYdX (which is always a possibility due to its nature as a derivatives exchange) they will have a very difficult time enforcing that, as there will be no person or body to hold accountable.

Market Makers

This does create a potential issue though, with the US being so tough on crypto, many market makers may decide (or be forced) to stop providing services to dYdX. This wouldn’t be an end-game situation, with many international and crypto native market makers likely to continue providing a service on dYdX, but it is something to keep an eye on as it develops, and react quickly to if issues arise.

Governance

dYdX governance is already live, and has been that way since the DYDX token launched (the reason revenue sharing cannot be unlocked until full decentralisation is a legal issue). Governance is based on the AAVE governance contracts and supports voting based on token holdings.

The governance process begins at the Community forum and is brought to life through dYdX Improvement Proposals (DIPs, similar to Ethereum’s EIPs). Click on the community forum link above to check out all the governance discussions currently taking place.

Check out their community dashboard here.

Grants

In January 2022 Reverie, a consultancy for DAOs, proposed running a grants program to aid dYdX’s growth by funding community projects. This passed with unanimous support, and 752k DYDX was moved from the Community Treasury to the grants multisig wallet.

The program has seen a massive increase in the number of active contributors working on development, marketing, education, and more. This really demonstrates the use case of decentralisation, allowing involvement from any outside party to further the project. Contributors are compensated for their efforts whilst improving a protocol they are likely invested in, what more could you want?

Check out their Retroactive Look at Grants V1 for an overview of the mission, what they’ve funded and achieved, and where the program hopes to go next. See here for a full list of grants approved.

Considerations and Drawbacks

Depositing Funds to dYdX

As dYdX operates on StarkEx, and will soon move to their own Cosmos SDK and Tendermint blockchain, the dYdX chain. Both are independent blockchain, which requires bridging over funds to use the protocol. This can result in high gas fees, which prohibits small retail traders.

dYdX, in an attempt to remove this barrier to entry, offer gas-free deposits. To be gas-free, you must deposit a minimum amount. dYdX’s article and rules conflict on how much this must be, but it is at a very minimum $500 for new users, and $1,000 for existing. This article states it’s double that.

This will definitely help attract users who are concerned about gas fees, especially when gas is very high, but there are some issues. Firstly, it is a promotion and will end at some point. Secondly, the minimum deposit is prohibitively high for many users.

The issue of no direct banking link, is, in my opinion, the largest barrier dYdX faces in becoming larger than centralised exchanges; and it is a big one.

I don’t believe it’s an issue when comparing to other DEXs such as GMX or Perpetual Protocol, as none have direct banking links. If a user has a DeFi wallet set up and wants to trade, the gas-free trading and considerably better experience on dYdX is a massive selling point, even with having to move their funds across blockchains.

However, for users new to crypto, the fact they can’t deposit directly from their bank account into dYdX is a major drawback. For experienced traders, the fact that they can’t withdraw their gains directly from dYdX is a pain point which would require them using a CEX anyway to bridge the gap. The question then is, why not just use the CEX in the first place?

Now, there are some key reasons discussed above, but you can see how this causes a sticking point in dYdX’s growth. In my opinion, once this barrier is addressed, the sky is the limit.

As DeFi matures, is trusted, and integrates with existing financial systems, I expect we will see dYdX partner with a company to offer direct deposits and withdrawals. Clearly, though, we have some way to go before that happens.

Note, we are yet to have details on how the dYdX chain will operate, so are unsure of how the issues above will be addressed - more information will be released in the future, and we will keep the community up to date.

DYDX's Invest-ability - A Side Note

The fact that full decentralisation is expected by the end of the year appears to be conveniently timed with the supply almost doubling overnight in Feb 2023. This is likely intentional, as dYdX are aware of the potential impact of such a large unlock on consumer confidence and token price. Whilst it is not malicious or an attempt to pump DYDX prior to the unlock in my opinion, it is something for us to keep in mind, as if the timeline slips, that could have massive impacts on the token price in the short term.

With the bearish sentiment in the market currently not expected to finish anytime soon, it is worth waiting for a change in market structure before considering investing in DYDX, unless you are averaging in over the long term. This is because if full decentralisation is pushed back, bear market is ongoing and unlock happens, the price could suffer in the short term.

We will do an update report on dYdX after decentralisation takes place.

Conclusion

dYdX is growing at an astronomical rate (looking back over the last 18 months). There is still a long way to go before it reaches it’s goal of being the ‘largest crypto exchange in the world’, but it’s certainly making strides in the right direction.

The laser focus on providing the best venue for traders is what differentiates them, which leads me to believe the lack of composability and ability to use money-lego’s, integrating directly with other protocols, will not cause any issues. All it will do is open up the market for other players, with more focus on composability, to carve out their own niche.

Note, we are not yet sure how the dYdX chain will impact the interoperability, there is a chance it could permit it and open that door for dYdX.

The issue of no direct banking links is certainly one to consider, but it isn’t a sticking point. At the moment, that is the standard across DeFi. If, like me, you believe the potential of DeFi is too great to ignore, and in the future the traditional world (including regulators and banks) will be forced to adapt or be left behind, then you believe this problem will resolve itself in time. For now, until we go mainstream, getting into DeFi will always have an element of difficulty.

Another point of contention is the gaming of trading rewards, and potential issues around regulation for market makers when dYdX is fully decentralised. It is vital that we continuously evaluate the market makers and liquidity on the exchange, although there have been no signs of it weakening. With the revenue they are able to generate, they clearly have the means to incentivise market makers onto the platform. Whether this will impact the percentage that could be used for revenue sharing with token holders remains to be seen, as well as what that revenue sharing model could look like.

No DeFi perp exchange has ever reached the revenue and valuation of dYdX, let alone fully decentralised at that level. However, if they succeed, they will have a clear competitive field, with no other company or protocol offering what they do.

The importance of their move to full decentralisation for crypto as a whole shouldn’t be understated, especially as they are testing a unique and potentially groundbreaking model by creating their own app-specific blockchain, and potentially addressing all the issues that come with that. This could open the door for others to copy the model and mark a move to app-specific chains.

If it is successful, it provides a clear case study for Cosmos app specific chains, with it not just working as a concept, but thriving in the real world. It is a great step forwards in blockchain technology, and towards the decentralised, open and fair future many of us in the crypto space hope for.

Not only this, but if dYdX succeed, and create a better product with this method, they will have an entirely clear competitive field, allowing them to differentiate and take on centralised exchanges, working towards their goal of being the biggest crypto exchange in the world.