dYdX: The Perp(etual) Futures of Trading

Please note that VanEck has a position(s) in the dYdX token described below.

We believe dYdX token is undervalued relative to its growth potential as it backs an essential product that generates substantial revenue amid a favorable industry backdrop. dYdX has established a strong product market fit while cementing a dominant market position. We observe improving tokenomics and see the planned migration to dYdX’s own blockchain in the Cosmos unlocking new revenue lines and greater demand for the native token.

dYdX is a decentralized exchange for on-chain derivatives trading. It is currently hosted on an Ethereum Layer-2 blockchain built by StarkWare. dYdX facilitates trading specialized financial derivatives, called perpetual futures, on crypto assets such as ETH and BTC. Perps, as they are called, are similar to traditional futures as both tie their prices to the spot prices of underlying assets. But, unlike traditional futures, perps have no expiry date. As a result, all perpetual futures contracts are cash-settled, and perp prices are tied to spot prices by an interest rate mechanism that charges the in-the-loss parties a penalty interest rate.

Conversely, the in-the-profit parties receive these payments. This interest rate adjusts the further away that the perpetuals prices drift from spot prices. Price convergence happens as the underwater parties liquidate their positions or as market participants step in to move the prices back to spot.

dYdX’s business model involves matching buyers and sellers of perpetual futures using the same central limit order book matching engine that is common across the financial industry. Traders onboard onto dYdX by depositing their USDC funds into a smart contract vault that acts as a margin account which mirrors the function of a traditional margin account such as one on the Chicago Mercantile Exchange. Margin is drawn to back trades based on a desired leverage ratio of up to 30x.

dYdX accrues revenues from fees on trading. Currently, fees are tiered by both a participant’s trading volume as well as the amount of dYdX tokens they hold – the higher the trading volume and/or the more tokens held, the lower the trading fees. The dYdX smart contract also dispenses tokens as a reward mechanism to rebate those who trade on the platform. Before there was a token, early users of the exchange received substantial value through an airdrop (7.5% of all tokens, worth $800M at the time) to reward their patronage of dYdX. Most importantly, dYdX is used as a tally-marker in governance voting decisions that affect the application. These voting rights allow holders to vote on important governance decisions like token inflation, community treasury spend, and future dYdX direction.

Similar to Uniswap, the fees from trading do not currently accrue directly to the token's value in any form. However, unlike Uniswap, fees are collected by the team behind dYdX - the dYdX foundation. To date, over $400M in fees have been generated on dYdX, and all of them have gone to the dYdX foundation. Using the governance voting rights afforded to the token, some sort of value transfer mechanism is expected to be implemented to give token holders more value eventually. This may take the form of token buybacks or remittances of fees to token holders.

Thesis:

In summary, we like the dYdX token for the following reasons:

1. Consistent Revenue Generation
2. Dominant Market Position with Room to Grow
3. Strong Product Market Fit with Expansionary TAM
4. Migration to Sovereign Blockchain With New Token Sinks and Revenue Possibilities
5. Improving Tokenomics

Consistent Revenue Generation

dYdX Market Share

Sources: dYdX, GMX, Dune as of 3/19/2023. Past performance is no guarantee of future results.

Dominant Market Position with Room to Grow

dYdX is a mature crypto application with a customer base of consistent, high-value users who generate substantial fees for the platform. In 2022, dYdX generated $137M in fees based upon $466.3B in volume from over 33,900 unique traders. By trading volume, dYdX is the clear market leader among on-chain perpetual futures platforms with over 70% market share. While its share of on-chain perps volume is high, when centralized exchange trading volume is added, dYdX retains only 2.96% of ETH and 1.23% of BTC perp market shares. Although the centralized market lead may appear intimidating, it presents a tremendous opportunity that dYdX has already been effectively seizing. This is because centralized crypto exchanges are closed-loop entities whose lack of transparency regarding order execution has led some – including the CFTC in a recent suit against Binance - to contend that exchanges are trading against customers or advantaging certain customers over others. These fears were partially confirmed amid the fallout of FTX. It was revealed that, FTX trading affiliate, Alameda was afforded trading advantages over other customers when it was exposed that FTX gambled with customer deposits. dYdX, by contrast, offers a more transparent product where fair ordering can be confirmed by confirmable on-chain data and customer funds are protected by verifiable code rather than trust placed in exchange operators. As a result, dYdX perp volume market share grew directly after the collapse of FTX. Perp volume market share grew from 0.9% and 1.8% to 1.23% and 2.96%, for BTC and ETH respectively.

Strong Product Market Fit with Expansionary TAM

This competitive positioning and product offering must also be viewed against favorable volume growth in crypto and broader financial derivatives. Perpetual futures monthly volume on BTC and ETH alone have grown from $377B in January 2020 to $1254B in January 2023. Meanwhile, the volume of all types of exchange-traded derivatives has grown from 18B contracts in 2019 to 61.6B contracts in 2022. Additionally, the use case of crypto derivatives, like perpetual futures, has massively expanded with the growth of Proof of Stake networks and DeFi, where stakers are rewarded with yield in volatile tokens. An increasing number of staking participants will seek hedging mechanisms to enable users to lock in the value of these awards. With the upgrade of Ethereum to a PoS network in September of 2022 and the coming Shanghai upgrade in April 2023, hundreds of billions of dollars can be potentially hedged.

dYdX Profitability

Sources: dYdX, DeFillama, Dune as of 3/23/2023. Past performance is no guarantee of future results.

Migration to Sovereign Blockchain with New Token Sinks and Revenue Possibilities

Going forward, our bull thesis on dYdX is supported by the anticipated migration of dYdX to its own Cosmos blockchain alongside continued improvements in tokenomics. The creation of the dYdX chain will not only lead to an improvement in trading throughput by as much as 100x but also new use cases for the token. As the dYdX blockchain will be based upon Proof of Stake, the dYdX token will become more useful as its value can be used to stake the network’s validators. Staking rates in similar proof-of-stake networks typically range between 40% and 70%. Likewise, the migration of dYdX to its own Cosmos blockchain enables dYdX to monetize its exchange better, using the data provision and colocation practices of traditional finance exchanges. In practice, this may mean charging for faster order execution, the deployment of trading servers closest to dYdX’s order router, or very fine real-time trading data. Building its chain will make it easier for dYdX stakeholders to host or build new applications offering related services - lending, spot trading, fiat-off ramps - with DyDx token holders getting a cut of the action. We observe strong commitments by both the team and the community to improve the tokenomics of dYdX. During the bear market, on-chain governance has reduced dYdX token emissions by decreasing trading rebates that are paid using dYdX tokens. On two separate occasions, governance approved a drop in rebates from 3.83M tokens every epoch (28 days) to 1.58M tokens per epoch. Likewise, the founders and investors of dYdX also agreed to push back their token unlocks further into the future to significantly diminish near-term dilution. Most notably for token value accrual, the dYdX team has informed the community that it plans to “decentralize fees,” which should tie more systematically the token’s value to the production of fees of the decentralized exchange.

Improving Tokenomics

Finally, we have a favorable outlook on dYdX because the team has effectively iterated on an intuitional grade product that has attracted usage from crypto’s most prolific market makers. To entice high-tier users, dYdX changed its fee structure by increasing price taker fees and decreasing market maker fees with an aim to reduce toxic order flow. This tailors its product to institutional market makers to ensure they are not being “picked off” by aggressive traders with better information. This contributes to a platform with higher order book liquidity. Thus, while other applications may charge higher fees or employ novel mechanisms that appeal to retail users and naïve, yield-seeking market markets, dYdX has created an institutional-grade product with the highest capital efficiency among its peers. In this respect, dYdX is set on competing with centralized crypto exchanges, and we believe it has the plan to accomplish it.

Capital Efficiency: TVL ($) vs. Turnover of TVL (Tx Volume/TVL)

Sources: CME, dYdX, Dune, GMX as of 3/25/2023. Past performance is no guarantee of future results.

Risks:

The risks to our thesis include the following:

1. Transparency Issues
2. Product Delays and Issues
3. Competition
4. Regulation

Transparency Issues

While we are bullish on dYdX’s ability to gain market share due to better capital efficiency, we find that the most significant risks to our thesis revolve around the opacity of the dYdX Foundation. Practically, this is best exemplified by the dYdX Foundation’s secrecy on the utilization of past trading fees, which have amounted to over $400M. The foundation also holds 22.3% of current and future dYdX tokens. Likewise, many in the community are uncertain about the structure of the dYdX foundation, which, while touted as a non-profit, appears to have investors with significant influence over the direction of the application as early investors hold 27.7% of dYdX tokens. We are also not certain of the relationship between the exchange and its major market makers. These transparency issues include exchange practices and statistics. While the future roadmap promises more openness, trade execution ordering is still a bit of a black box, and there is speculation that trading activity statistics are unreliable due to wash trading on the application.

Product Delays and Issues

Beyond issues of openness, dYdX has experienced significant product launch delays. Initially, the v4 migration was scheduled by year-end 2022 and has since been pushed back further from 2Q 2023 to the end of 3Q 2023. Further delays would call into question the execution abilities of the team, their ability to scale throughput of trading volume, and their commitment to transparency. Most importantly, any inability to effectively scale dYdX would see its market makers quickly leave for better trading venues.

Additionally, there is some question about the effectiveness of the dYdX liquidation system. This is because dYdX eliminated its Safety Module which effectively backstopped liquidations by providing liquidity in extreme cases where market makers pull orders due to market volatility. In these extreme circumstances, an underwater trader being forced out of a trade could cause a series of cascading liquidations that untethers dYdX derivative prices from spot. This could bankrupt market makers on the platform and lead to a substantial loss of principally important users. In effect, dYdX reduced inflation but may have introduced additional instability in the process. Finally, it is important to note that dYdX’s migration to the Cosmos is far from certain. The consensus mechanism that powers Cosmos, Tendermint, will have to undergo profound upgrades to ensure it can handle the demands of dYdX’s order book and scaling requirements. Likewise, dYdX must ensure it does not lose users wedded to the Ethereum system when it leaves for the Cosmos.

Competition

Because of the competitive landscape taking market share and the consequent move to lower fees, we see greater-than-expected fee deterioration as a potential issue for dYdX. Competition is ample, and on-chain exchanges such as GMX have found product-market fit among naïve market makers (and the traders seeking to take advantage of them). While we expect dYdX’s fees to converge from an approximate take rate today of around 2.90bps to the CME approximate take rate of 0.03bps over the next 7 years, dramatic moves by competitors to win market share through low fees or massive subsidies could quickly deteriorate dYdX’s business. This may extend to better, cheaper competing products from centralized spot exchanges like Coinbase or traditional finance venues like Nasdaq. While it is important to note that dYdX’s customer base cares about issues beyond price, the competition to become the crypto derivatives price discovery epicenter is intense and crypto derivatives trading is likely a Pareto-type industry.

Regulation

Finally, and most importantly, immense regulatory pressures have recently become prominent in the space. The SEC regulates crypto by an exceptionally broad interpretation of existing laws and aggressive enforcement proceedings. Recent enforcement and obstruction action against Binance, Justin Sun, and Kraken demonstrate an agency committed to asserting its control over the industry, increasingly at the expense of the businesses in crypto. As a result, despite a strong “geo-fence” to prevent US citizens from accessing dYdX, given that most of the team is based in the US, we believe regulatory action may come at any time.

Valuation^*

We base our valuation on a DCF model that estimates cash flow in the year 2030, assigns it an FCF multiple, and discounts back to the present day. In our base case, we estimate FCF to be $1.94B. We apply a terminal multiple of 40x to arrive at a valuation of $77.6B. We discount it back to present at 20% to arrive at a $16.05B valuation. A fully-diluted token count of 1B brings us to a valuation price of $16.05 per token, assuming a 1B supply.

In our valuation model, we estimate revenue by ballparking the total value of the digital asset market - both off-chain and on-chain assets. We then apply an expected crypto asset trading turnover rate of 250% per annum by comparing current tradfi and crypto assets; we also calculate a ratio of expected perpetual futures volume to spot volume to derive perp trading volume. We then factor a take rate on that volume, 0.03 bps, which roughly corresponds to the take rate of the CME. With that volume, we estimate a breakdown between DEX trading and CEX trading, 25/75, respectively, and then approximate the on-chain derivatives market share of dYdX: 75%. We then deduct expenses, taxes, and security fees to arrive at an approximate free cash flow to the token holder. Thereafter, we add an additional 15% of revenue we believe will be derived from data monetization vectors such as colocation, data services, and MEV to the bottom line.

dYdX Model Flow Chart:

Source: VanEck Research as of 3/27/2023.

^* The above is not intended as financial advice or any call to action, a recommendation to buy or sell dydx, or as a projection of how dydx will perform in the future. These are solely the results of a simulation based on our research, and are for illustrative purposes only. Please conduct your own research and draw your own conclusions.

To receive more Digital Assets insights, sign up in our subscription center.