Diving into dYdX v4 Improvements in token economics and valuation prospects

Exploring the Latest Upgrades in dYdX v4 Enhancements in Token Economics and Valuation Potential

Author: Gryphsis Academy, Medium; Compiled by: Songxue, LianGuai

TL;DR

1. dYdX was founded in 2017 and is a decentralized perpetual exchange that integrates lending, leverage trading, and perpetual contracts. dYdX has completed four rounds of financing and has received investments from well-known institutions such as LianGuairadigm and A16Z.

2. After migrating to Starkware in 2021, dYdX solved the issues of TPS and gas fees, with a 24-hour trading volume exceeding $800 million, occupying a leading position in the perpetual Dex market.

3. dYdX adopts a tiered transaction fee mechanism, charging lower fees to Maker and large traders to convert liquidity. Its fees are lower than other exchanges. In addition, as an incentive for early adopters of the upcoming v4 version, they are launching $DYDX token rewards to further enhance their competitively fee structure.

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4. Highlights of v4: (a) dYdX v4 migrates to a Cosmos SDK-based Layer1 chain. (b) Off-chain matching and on-chain consensus transaction process. (c) Placing/canceling orders does not require gas fees, only fees are charged upon completion. (d) dYdX achieves fully decentralized governance.

5. Compared to v3, v4 has made minor improvements in token standards, governance, discount features, trader rewards, staking, Gas, and fee allocation, increasing the intrinsic value of the token.

6. Why choose Cosmos: (a) Cosmos provides decentralization and high performance. (b) Decentralization in the v4 version reduces the risk of regulatory scrutiny. (c) The availability of USDC on Cosmos enhances dYdX’s liquidity. (d) Cosmos provides dYdX with better scalability and composability.

7. In our evaluation, the staking and fee allocation of Layer 1 increase the utility and value capture potential of the token. Circle has launched native USDC on Cosmos, which enhances the token’s liquidity. Overall, these factors undoubtedly enhance the fundamentals of the $DYDX token and bring positive news. While these are exciting prospects, we must also pay attention to potential security implications.

1. Protocol Overview

dYdX is a distributed perpetual contract exchange currently hosted on the Ethereum Layer 2 blockchain built by StarkWare. It relies on the security of Ethereum and uses zero-knowledge proofs to accelerate transactions and reduce transaction fees. dYdX adopts an order book model and has performed well in terms of 24-hour trading volume and daily active users (DAU). It is the largest and most widely used perpetual contract exchange in the market. The daily trading volume exceeds $800 million, surpassing the comprehensive trading volume of protocols such as Kwenta, GMX, gTrade, and Vertex.

24H Trading Volume Comparison

2. Team and Funding

dYdX was founded in 2017 and has a team with extensive experience and technical expertise in the blockchain industry. It is worth noting that dYdX has a close relationship with the centralized exchange Coinbase. Firstly, some core members of the dYdX team previously worked at Coinbase, including its founder Antonio Juliano, who served as a senior engineer at Coinbase. Secondly, Coinbase actively participated in dYdX’s seed funding round and provided liquidity support for its borrowing and lending products. In addition, dYdX’s current CEO is Charles d’Haussy, who previously served as the Global Head of Business Development at ConsenSys and as the FinTech Director at the Hong Kong Government’s InvestHK.

According to the information provided, the executive team and board members of dYdX graduated from globally renowned universities and have held positions at well-known companies such as the Wharton FinTech Center, AIG, LinkedIn, etc. This highlights the team’s rich expertise and experience in the finance and technology fields.

As of now, dYdX has completed four funding rounds, raising a total of $87 million. It has a strong lineup of investors with abundant funds, including LianGuaradigm, Polychain Capital, Andreessen Horowitz (A16Z), and renowned crypto market maker Wintermute.

3. dYdX’s History and Current Development

dYdX was initially built on the Ethereum mainnet, but the DeFi summer explosion led to exorbitant gas fees and congestion issues on the Ethereum network. These challenges significantly affected the user experience. To solve the gas fee problem, in 2021, dYdX migrated to a more scalable Ethereum Layer 2 platform developed by StarkWare. This move effectively addressed the issues related to transaction speed (TPS) and gas fees.

After the migration, dYdX’s trading volume increased significantly, with a total trading volume of approximately $10 trillion for dYdX v3, firmly establishing its position as a leading decentralized perpetual contract exchange in the market.

Top-ranked Derivatives DEX by Market Cap

4. Business Segments and Trading Cost Improvement

dYdX offers a comprehensive range of functionalities, including borrowing and lending, leveraged trading, and perpetual contracts. Leveraged trading has an integrated borrowing function where the funds deposited by users automatically form a liquidity pool. If there is insufficient funds during a transaction, the platform will automatically borrow on behalf of the user and pay interest on their behalf. dYdX increases liquidity by charging lower fees to Makers, and the larger the monthly trading volume, the lower the fee rate. This mechanism is more favorable to institutions and professional traders. As shown, dYdX’s lower transaction fees give it a significant advantage among major cryptocurrency trading platforms.

The transaction fees on dYdX vary based on the trading volume in the last 30 days. In dYdX v3, there are six tiers, with higher tiers corresponding to larger trading volumes. This structure allows for lower fees for Maker and Taker as the trading volume increases. It is worth noting that when the trading volume in the last 30 days exceeds or equals $50 million, the Maker fees drop to zero.

According to the official plan, in the first 120 days after the launch of v4, Maker will incur order fees unless the trading volume in the last 30 days reaches or exceeds $25 million. At this time, the Maker fees will be waived. Additionally, when the trading volume in the last 30 days reaches $125 million and exceeds 0.5% of the market share, Maker will qualify for transaction rewards again. It should be noted that this is the current situation and fee tiers may be adjusted by the governance community based on real circumstances.

Comparison of the fee structure between DYDX V3 and DYDX V4

Meanwhile, according to the latest proposal passed as of October 2nd, the community plans to distribute $20 million worth of DYDX tokens to early adopters of v4 within 6 months. This is to incentivize users to transition to v4 and seamlessly migrate to the dYdX chain. This measure is expected to effectively drive adoption of v4 and support its early growth. It also strengthens dYdX’s fee advantage.

5. Tokenomics of dYdX V4

5.1 Token Allocation and Locking Schedule

A total of 1 billion DYDX tokens have been issued and will be gradually released over a period of five years starting from August 3, 2021. Since the launch of DYDX, several governance proposals (DIP 14, DIP 16, DIP 17, DIP 24) have led to changes in the initial allocation. The current allocation includes:

• 50.0% (500,000,000 DYDX) allocated to the community, of which 14.5% (144,693,506 DYDX) is based on the trading reward formula, 5.0% (50,309,197 DYDX) is allocated to past users who completed specific transaction milestones on the dYdX Layer 2 Protocol (retroactive mining reward), 5.2% (52,458,925 DYDX) is based on the market maker reward formula, 24.2% (241,735,862 DYDX) is allocated to the community treasury and reward treasury, 0.6% (5,753,430 DYDX) is allocated to users who collateralize USDC in the liquidity pools, and 0.5% (5,049,079 DYDX) is allocated to users who collateralize DYDX in the safety staking pool.

• The other 50.0% (500,000,000 DYDX) is primarily used for distribution to investors and employees.

Within the first five years of launch, governance can adopt a maximum annual inflation rate of 2% to increase the supply of DYDX and ensure the resources needed for the maintenance, development, and expansion of the protocol. Any inflation measures must be approved through governance proposals and are subject to a maximum limit of 2% per year.

Current Allocation

Allocation Change

Locking Plan

5.2 Token Utility and Value Capture

In version 3, the $DYDX token has three main utilities: governance, fee discounts, and staking. It is worth noting that the security staking module has been disabled in a proposal in October 2022.

In contrast, version 4 introduces the new feature of validator staking. Through version 4, dYdX achieves complete decentralization, governed entirely by token holders. This allows $DYDX token holders to define the token’s functionality, add or remove markets, and modify parameters of dYdX v4. Building on the success of perpetual contracts, dYdX can also enter the spot market, evolving into a multi-functional DeFi application with high user retention rates.

6. Marginal Improvements of dYdX v4

6.1 Key Features of the New Version

The new version, v4, of dYdX will be released on the mainnet in the fourth quarter of 2023. Here are the key features of this new version:

1) Layer 2 → Replacing Layer 1

dYdX v4 no longer relies on the Ethereum mainnet but operates within the Cosmos ecosystem, utilizing Cosmos SDK and CometBFT POS mechanism.

v4 adopts a proof-of-stake consensus mechanism supported by two types of nodes: validators and full nodes. Validators are responsible for storing orders, processing transactions, and generating new blocks through the consensus process, while full nodes do not participate in the consensus mechanism but handle transaction propagation and block processing.

V4 System Architecture

2) Order Mechanism Update

When placing orders on v4, the following process will be followed: user initiates the transaction on the frontend → transaction is sent to validators → order matching and creation of new blocks → consensus process: 2/3 of the validating nodes confirm through voting → data is updated and returned to the frontend through an indexer.

3) No transaction Gas fees

In dYdX v4, each validator maintains an off-chain order book. User order submissions and cancellations are propagated off-chain through the network. Only when orders are matched in real-time, the transaction results are submitted to the blockchain. This means that user order submissions and cancellations are considered off-chain operations and do not require payment of transaction Gas fees. The protocol only incurs transaction fees when orders are completed on-chain.

4) Fully decentralized governance

Based on the approved DIP 18-Operations SubDAO proposal, dYdX DAO will be granted full authority over the protocol, transferring control from dYdX Trading Inc. This means that dYdX’s operations will be fully decentralized, and the community will play a crucial role in facilitating the transition by establishing an operational SubDAO to ensure seamless transformation of the operational framework.

6.2 Comparison between v3 and v4

Based on the v4 incentive plan, as well as the proposed adoption and token migration plan, we have identified six areas of marginal improvement of v4 compared to v3, namely token standards, governance, discounts, staking, Gas fee payments, and fee allocation. For a detailed comparison, please refer to the table below:

6.3 Why choose Cosmos

1) Decentralization and high performance

The implementation mechanism of the order book and matching engine in dYdX requires high throughput. Currently, the Ethereum network faces scalability issues, while the security, speed, and scalability of the Cosmos network can help dYdX address these challenges. This, in turn, provides traders with faster transaction speeds, lower fees, and a fully decentralized trading experience.

2) Regulatory flexibility

According to the latest ruling by the U.S. Commodity Futures Trading Commission (CFTC) in September, three DeFi protocols, Opyn, Inc., ZeroEx, Inc., and Deridex, Inc., have been accused of illegally offering digital asset derivatives trading and face fines of hundreds of thousands of dollars. Compared to the Securities and Exchange Commission (SEC), the CFTC enforces stricter regulations on cryptocurrencies. Considering this trend, the CFTC may expand its regulatory scope to include more smart contract-based decentralized perpetual contract trading platforms and require them to implement Know Your Customer (KYC) procedures. It’s worth noting that all three accused protocols are entities registered in California. Similarly, dYdX Trading, Inc., registered as a single entity in the United States, faces the same situation. In v3, dYdX Trading, Inc. controlled the protocol and enjoyed all fee revenues, making it susceptible to regulatory scrutiny due to its centralized management approach. Despite dYdX’s cautious approach regarding regulatory issues in the United States, not providing services to U.S. residents, it is evident that transitioning to full decentralization is a wise move in the face of increasingly stringent regulatory trends. In v4, dYdX will be fully decentralized, and dYdX Trading, Inc. (the platform operator) will no longer run any centralized components. dYdX will be managed and controlled in a fully decentralized manner by the community. With full decentralization, regulatory bodies will no longer classify dYdX as a “centralized exchange,” allowing dYdX to expand the market and reach more users.

3) Cosmos Launches USDC

As a new Layer 1 chain, dYdX has its own set of validators and requires users to connect through a cross-chain bridge. As Ethereum co-founder Vitalik Buterin pointed out, the security of cryptocurrency assets depends not only on the original network but also on the other chains that the assets go through when being packaged, locked, and transferred through a cross-chain bridge. Cross-chain bridges have been repeatedly targeted by hackers and pose a significant threat to the flow of large amounts of funds. The inability to address the risks of cross-chain bridges would be fatal for dYdX, especially considering its large user base. Recently, Circle launched native USDC on Cosmos, which helps improve dYdX’s liquidity and reduces the need for and associated risks of cross-chain asset transfers. This is one of the reasons why dYdX chose Cosmos.

4) Scalability and Composability

dYdX transactions are recorded on the blockchain in discrete “blocks.” Each block can only accommodate a limited amount of data and is processed regularly. As the blockchain attracts more users, the limited block space becomes more coveted, leading to increased gas fees. To address this issue, dYdX v4, supported by Cosmos, introduces the concept of application chains.

Unlike most Rollups, application chains are self-contained blockchains tailored for specific purposes. Builders of application chains have the freedom to customize every aspect, from underlying protocols to user interfaces. Application chains have their own unique consensus protocols and offer extensive customizability, opening up entirely novel functionalities while enhancing decentralization and scalability. Although dYdX v3 is on Starknet (an L2 solution), v4 will drive the shift towards application chains. For dYdX, the application chain model provides a superior combination in terms of decentralization, scalability, composability, and transaction speed compared to the current Rollup solutions.

7. Outlook for dYdX v4:

Currently, for dYdX v3, all transaction fees flow to dYdX Trading, Inc. Apart from being used for governance and staking to obtain fee discounts and platform rewards, the wealth effect of $DYDX tokens has been relatively minimal, hindering price appreciation. In dYdX v4, this drawback is expected to be addressed as there will no longer be a centralized entity receiving fee income. Additionally, the dYdX community has proposed utilizing $DYDX tokens for staking and protecting the dYdX chain, providing more substantial utility and purpose.

1) Layer 1 Staking Increases the Demand for $dYdX Tokens

The Safety Staking Module (SSM) is a protective mechanism of the dYdX protocol used to address funding shortages, such as smart contract risks. Previously, fund providers (stakers) were rewarded for bearing these risks from the genesis supply. In v3, staking $DYDX tokens in the safety module was a practical feature of the token, but it didn’t significantly drive the demand for purchasing dYdX tokens. In the case of a funding shortage in the protocol, the value of funds staked by stakers may be at risk of reduction. Therefore, the effectiveness of the SSM mechanism is questionable since smart contract risks could lead to a decrease in token price and a significant devaluation of the safety module reserves. Consequently, on November 28, 2022, the community passed the DIP17 proposal, shutting down the Safety Staking Module.

According to the official announcement, after the release of dYdX v4, dYdX Chain will become a proof-of-stake blockchain network. In this stage, v4 will require an L1 protocol token for validators to stake, ensuring the security of the network and delegating its management to the stakers of this L1 token. Currently, the dYdX community has chosen $DYDX as the L1 token for the dYdX Chain. As dYdX adopts a Proof-of-Stake mechanism, the L1 token is used for validator staking. Anyone who stakes a certain amount of tokens has the opportunity to become a validator, ensuring the security of the chain. Although we are currently unsure of the exact amount of $DYDX tokens required for validator staking, the specific details of the available nodes or delegation mechanism, it can be anticipated that this new staking model in v4 will replace the previous SSM staking model in v3, increasing the demand for $DYDX tokens and potentially driving up its price.

2) Fee Distribution Enhances Token Foundation

According to the preliminary concept in the official documentation, after each transaction, a portion of the transaction fees will be automatically returned to users as transaction rewards through smart contracts. After each transaction, a portion of the commission will be directly sent to users as transaction rewards from the smart contract. The maximum transaction reward for each transaction will not exceed the processing fee of that transaction. Since transaction rewards are limited to the net transaction fees generated by the block protocol and the distributed transaction rewards may be based on a per-block basis, the protocol can incentivize transaction activity without exceeding its budget, saving a large amount of funds and reducing token inflation.

As planned, v4 will not charge GAS fees, only transaction fees. $DYDX tokens are likely to be used to pay for these transaction fees. This significantly expands the practical use of the token and increases its intrinsic demand. Furthermore, the allocation of transaction fees is entirely determined by the community. If the community approves the proposal, more income from the platform will flow to $DYDX token holders. This allows the $DYDX token to derive more value from the development of the protocol.

3) Introducing Native Stablecoin Enhances Asset Security

Circle recently announced that Cosmos will support the native USDC. The introduction of on-chain native stablecoins not only increases the liquidity of $DYDX tokens but also reduces the need for and associated risks of cross-chain asset transfers, ensuring the security of assets on the dYdX chain.

From an objective and rational standpoint, we believe that dYdX v4 will empower $DYDX tokens and bring a range of benefits. However, it is necessary to acknowledge that the decision to create a new chain instead of building on Ethereum also brings potential security risks:

L2 Rollup is still superior to Cosmos as it relies on the excellent security of Ethereum without the high cost of maintaining its own security. If users have confidence in the underlying Ethereum blockchain, they are likely to have confidence in the security of dYdX transactions on L2 as well. However, in v4, users need to trust a new set of validators on the dYdX chain. Additionally, staking requires the payment of $DYDX tokens, but the value consensus of $DYDX is not as firm as ETH.

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