Introduction
dYdX is a tool for people who hopefully know what they are doing. Trading something as volatile and explosive as crypto with leverage can go very well but also very bad. To be able to do this, the trading exchange needs to be working well, react on time and have enough liquidity.
dYdX does something well as it is one of the largest decentralised exchanges by trading volume. It’s not just a normal decentralised exchange, but one that allows users to trade leverage and perpetuals. If you are not familiar with these terms, I recommend having a look at this great summary here.
Leverage generally refers to borrowing money to invest and the financial industry has evolved this simple concept into much more complex ways to bet on the movement of an asset. Perpetuals, the thing dYdX advertises on their website, is a special way to trade futures contracts that do not expire.
This is how dYdX does it:
To evaluate the token, we don’t need to fully understand the concept. It’s enough to know that this is an advanced form of trading with leverage used mainly by professionals and other people that know what they are doing.
On the product design side, dYdX operates in a hybrid model where parts are run on-chain and others off-chain, utilising the best of both worlds. The plan however, is to fully decentralise with version 4, which is to be released by end of 2022:
tldr;
🚢 The top priority is to release the next version of the protocol, V4, by end-of-year 2022
✅ dYdX V4 will be fully decentralized, with no central components
❎ No central party (including dYdX Trading Inc.) will have the ability to receive trading fees on dYdX V4
🪦 The current dYdX perpetuals protocol will eventually be deprecated after the migration to dYdX V4 is complete
The team behind dYdX has always been driving technological innovation of their protocol. Starting off on Ethereum, they migrated to layer 2 with starkware and now plan to build their own blockchain on cosmos.
The implications of this on the token could be interesting and we will have a look at what might happen.
Tokenomics
The token is mainly used for governance at the moment and has little other use than staking within the safety module and a discount on trading fees, but V4 might bring some innovation.
(A zoomable version of the diagram can be found here.)
dYdX Protocol
The protocol itself includes the exchange, where traders can deposit funds and trade. This part of dYdX runs on layer 2 and thus allows for great gas efficiency. The funds users deposit are used for trading or as collateral for leveraged positions. The more one deposits, the bigger size trade can be executed.
Traders who hold dYdX tokens receive a discount on trading fees and all traders, regardless of holdings, are eligible for additional token rewards based on trading volume via a trade-to-earn program. This in theory, should incentivise trading and make traders hold onto the tokens to receive the discount. This incentive ties in nicely with the exchange as it requires traders to trade and provide the liquidity to make the order book work.
The liquidity module provides liquidity for USDC:dYdX pairs trading on exchanges and liquidity providers are rewarded with dYdX tokens from the genesis supply.
The safety module protects the protocol in shortfall events (smart contract risk etc.) by paying out funds in dYdX. Funding providers (stakers) are rewarded for taking risk with a dYdX yield from the genesis supply. Stakers funds might get slashed in the event of a shortfall. The effectiveness of this mechanism is questionable as a smart contract risk would likely lead to the token price dropping and the safety module reserve becoming worth a lot less. Using an uncorrelated asset might be a better idea here.
Stakers can withdraw funds to the end of each epoch.
dYdX Community
There is no formal DAO, but the community can create proposals and vote for them. Token holders also decide over the distribution of the treasury that was filled with dYdX genesis supply tokens.
dYdX Trading Inc.
With plans to fully decentralise by the end of 2022, the Trading Inc. centralised corporation will play a far less significant role. Currently however, it runs the Order Book and Matching Engine and collects all fees coming from traders on the dYdX exchange.
The corporation also develops the dYdX software with input from the foundation and the community.
Distribution and Unlocks
A total of 1 billion dYdX tokens have been minted and allocated to the groups shown below on August 3rd 2021. The tokens will unlock over a 5 year period.
From their docs, this breaks down as follows:
50.00% as community rewards split up to:
25.00% to users who trade on the dYdX Layer 2 Protocol based on a combination of fees paid and open interest (User Trading Rewards)
7.50% to past users who complete certain trading milestones on the dYdX Layer 2 Protocol (Retroactive Rewards)
7.50% to liquidity providers based on a formula rewarding a combination of uptime, two-sided depth, bid-ask spreads, and the number of markets supported (Liquidity Provider Rewards)
5.00% to the Community Treasury
2.50% to users staking USDC to a liquidity staking pool (Liquidity Module)
2.50% to users staking dYdX to a safety staking pool (Safety Module)
27.73% to past investors
15.27% to founders, employees, advisors, and consultants of dYdX Trading or the Foundation
7.00% to future employees and consultants of dYdX Trading or the dYdX Foundation
The allocation is unlocked over the period of 5 years with a big first unlock coming up soon in January 2023. Due to the large allocation to employees, investors and founders this upcoming unlock could be quite significant.
Another interesting point is a potential 2% annual inflation starting 5 years after launch. Token holders can continuously decide whether to add this 2% inflation or not but it is capped at max. 2%.
At the time of writing the dYdX market cap has reached about 10% of its fully diluted market cap, showing that there will be a lot of tokens (90%) still added to circulation during the next 5 years.
This additional emission of tokens will have to be met by a lot of demand and will dilute early investors' share. In other words the demand for the token will have to grow by another 90% in the coming 5 years to maintain the current price.
Demand Drivers
Where could this demand come from? The strongest reason to hold dYdX tokens seems to come from the discount on trading fees. Looking at the fee structure, one can see that with a decent trading volume, traders might also run up a nice sum of fees.
Holding a bunch of dYdX tokens could reduce these fees by up to 50% on the highest VIP tier. A trader would have to hold more than 5m tokens, but lower tiers offer good discounts helping traders to reduce their costs and increase their trading return on investment.
Staking dYdX in the safety module is one of the token utilities, but I can't really see it being a demand driver. The reward for staking is more of the same tokens and I wouldn’t see this as a strong driver for people to buy the token in the first place (some won’t even call this staking). Perhaps in combination with the discount on trade fees, traders would stake their tokens they own anyway.
Looking at revenue, dYdX places third among dapps with a 222m half-year revenue.
Earning power like this is always a driver for token demand even though currently all of the revenue, collected from fees, goes to dYdX Trading Inc. With plans to fully decentralise with V4, we would likely see this revenue go to the community and perhaps also find its way back to token holders.
Value creation and value capture
dYdX managed to be one of the earliest derivatives trading protocols that was not completely centralised. With its hybrid model and constant technical innovation (moving from Ethereum, to Layer 2 and now onto its own chain on Cosmos), dYdX has created plenty of value for traders.
Leaving aside how they will manage to fully decentralise, a lot of the value creation in the past came from the hybrid approach of allowing users control over their assets, while also utilising the speed and efficiency of a centralised, off chain order book and centrally managed liquidity.
The protocol could gain in value by offering all of this in one decentralised exchange. The speed and execution of trades, the deep liquidity and the fully decentralised nature allowing users control over their funds. With more traders joining the exchange, leading to a higher trade volume, the fees would also increase.
Unfortunately, it currently does not accrue to token holders. The dYdX Trading Inc. takes the fees collected from traders and none of it goes to token holders or a community governed treasury.
There is always a degree of value capture through owning a piece of dYdX as a business, but since the revenue does not accrue to some community owned treasury or DAO, the impact on the token would be minimal.
The current community treasury gives voters governance rights over funds, but the funds came from a fixed allocation from the genesis supply and don’t have any inflow from the protocol's revenue.
All of this might change with V4 and it will be very exciting to see what the team is going to build. The forums already see discussions around how the future tokenomics could look like, including a voting escrow token and gauges to distribute rewards.
Closing thoughts
Admittedly, dYdX tokenomics are quite boring, but the fact they keep innovating on the technology side gives hope for innovation on the token side too. The forums indicate potential changes and simply giving token holders decision power over the revenues could bring a lot of interesting changes.
It would align the token and protocol a lot better and value created would accrue to token holders. Certainly something to watch.
The worrying part is the number of tokens still to be emitted by the protocol and the upcoming unlocks. Also something to watch.
All in all dYdX shows that tokenomics don’t have to be super complex and simple mechanisms such as discount for fees can be an incentive making the token worth holding.
This is amazing =)