DWF Labs Research: Deep dive into the economic model of on-chain derivatives exchanges

Written by: DWF Labs Research

Compiled by: Xiaobai Navigation coderworld

Introduction

in ourIn the previous article, we explore decentralized derivativesexchange(or Derivatives Dex) and the evolution and potential development of existing Derivatives DEX. This article takes a deep dive into decentralized derivativesexchangeCurrent token economics, analyzing the different mechanisms used by each protocol, and discussing potential future development directions.

Why do tokenomics matter?

Token economics are critical to the growth and stability of the protocol. After experiencing “DeFi Summer”,Xiaobai NavigationLiquidity mining successfully provided startup capital for the protocol in the early stages, but the mechanism was ultimately unsustainable in the long term. This mechanism attracts profit-seeking capital and contributes to a vicious cycle known as “mining and dumping,” in which investors who provide funds are constantly looking for the next protocol that provides higher returns, while abandoned protocols are harmed.

One example is Sushiswap's vampire attack on Uniswap, which successfully attracted a large amount of TVL at first, but was ultimately unsustainable. At the same time, protocols like Aave and Uniswap’s product-first focus successfully attracted and retained users, while sustainable token economics helped solidify their status as market leaders, which they remain today. leading position.

While product-led growth is important, token economics are also what differentiate derivatives DEXs in a highly competitive market. Tokens represent users’ judgments of the protocol’s value based on their activity, similar to how stocks reflect company performance forecasts. Unlike traditional markets, token prices often precede widespread awareness and growth of crypto projects.

Therefore, it is important to have token economics that can accumulate value from protocol growth. It is also important to ensure there is a sustainable token economy that provides adequate incentives for new users to join. Overall, good token economics are key to achieving long-term growth and preserving protocol value.

Current status of derivatives DEX

before usHindsight SeriesIn the article, we extensively introduced the evolution and mechanism of derivatives DEX. Now, let’s dive into the token economics of these protocols. dYdX is the first to launch sustainability on the chain in 2020contractis one of the projects and launched its token in September 2021. The token is generally considered highly inflationary due to the release of rewards from staking, liquidity providers (LPs), and trading as it does not provide much utility to its holders beyond transaction fee discounts.

GMX enters the market in September 2021 and aims to solve the unsustainable issue of emissions. GMX is one of the first companies to introduce the Peer-to-Pool model and user fee sharing mechanism, which generates revenue from transaction fees, with the maincryptocurrencyand payment in the form of project native tokens. Its success has also led to the creation of more Peer-to-Pool model systems, such as Gains Network. It differs in its staking model and revenue sharing parameters, levying lower risks on users but generating lower returns.

Synthetix is another DeFi protocol in this space that supports multiple perpetualcontractFront-end for exchanges and options exchanges such as Kwenta, Polynomial, Lyra, dHEDGE, etc. It uses a synthetic model where users must put their SNX tokens as collateral to borrow sUSD to trade. Users receive sUSD fees from all front-end transactions.

A comparison of derivatives DEX token economics

The table below shows how different protocols compare in terms of token economics:

Factors to Consider in Designing Good Token Economics

Well-designed token economics require careful consideration of various factors to create a system that aligns the incentives of participants and ensures the long-term sustainability of the token. We discuss various factors below based on the current landscape of derivatives DEX token economics.

1. Incentives and rewards

Incentives and rewards play an important role in encouraging user behavior. This includes staking, trading, or other mechanisms that encourage users to contribute to the protocol.

pledge

Staking is a mechanism whereby native tokens are deposited into the protocol in exchange for earnings. The revenue received by users is either obtained through sharing of handling fees (these handling fees may be mainstream coins or stable coins in the market), or through the issuance of native tokens. There are three main types of staking in the protocols we analyzed:

• Divide handling fees among mainstream coins or stablecoins

• Divide handling fees into native tokens

• Get the release of native token inflation

As the table shows, fee sharing has proven effective in incentivizing users to stake their tokens. The table reflects recent changes to token economics by dYdX and Synthetix, including the introduction of 100% fee sharing for dYdX v4 and the elimination of inflationary issuance of SNX.

Previously, dYdX v3 had aSafetySex and liquidity staking pools, which issue inflationary DYDX rewards, as these pools do not directly benefit from the trading volume on the platform. In September/November 2022CommunityAfter the vote, these two pools were abandoned as they did not really serve their purpose and were not efficient for the DYDX token. With v4, handling fees generated by transaction volume are returned to stakers, incentivizing users to stake for profit.

GMX utilizes two types of staking to distribute its rewards, both in the primary token (ETH/AVAX) and in its native token. GMX, Gains Network, and Synthetix have very high token staking rates, indicating that rewards are sufficient to incentivize users to provide upfront capital and keep their stake within the protocol. It’s difficult to determine what the ideal incentive mechanism is, but partially paying fees in major tokens/stablecoins and introducing inflation-released rewards for native tokens has proven effective so far.

Overall, staking has the following benefits:

• (1) Reduce the circulating supply of tokens (and selling pressure)

  • This approach only works if the benefits generated are not purely handouts to ensure sustainability

  • If the gains generated are in major coins or stablecoins, selling pressure will be reduced as users will not have to sell tokens to realize their gains

• (2)pledgeToken value growth

  • As the protocol grows and the fees generated per token increase, the value of the token can grow indirectly

  • Providing a stable yield for a token can entice non-traders to participate solely for the purpose of earning a yield

However, depending on the goals of the protocol, there are several factors to consider when implementing staking:

• (1) Persistence and type of reward

  • Having stable returns is important considering that risk-averse users don’t need to sell tokens to “realize” gains

  • The release rate is also important to ensure that the benefits received by users are not too volatile and can be sustained over a period of time

• (2) Reward suitable users

  • Lower barriers to entry and ease of accessing rewards (no upfront capital, no need to cash out, etc.) will likely attract mercenary-like users, thus diluting rewards for active users (active traders, long-term holders, etc.)

Our Thoughts: Staking is a common way to reduce the circulating supply of a token in most protocols. This is a great way to align with user interests, especially if the native token is required as collateral (such as SNX), which reduces the volatility of user positions through yields. If rewards are issued based on partial fees and mainstream coins/stablecoins, then the effect of staking will be more positive and long-term, which may be more suitable for most derivatives DEXs with good trading volumes.

Liquidity Provider (LP)

Liquidity providers (LPs) are particularly important for derivatives DEXs, especially for Peer-to-Pool models, as this will allow them to support more platform trading volumes. For the Peer-to-Pool model, LP becomes the counterparty of traders on the platform. Therefore, the profit share from the fees must be enough to offset the risk of losing to the trader.

For order book models like dYdX, LP is a way for users to earn rewards. However, most TVL still comes from market makers, and the rewards issued by DYDX are purely inflationary. As a result, the LP module was deprecated in October 2022. Synthetix is an exception where stakers are effectively LPs on the platforms it is integrated with (like Kwenta, Polynomial, dHEDGE, etc.) and receive fees from trading volume.

Both GMX and Gains Network adopt a Peer-2-Pool model that requires LPs to serve as counterparties to transactions executed on the platform. Compare these two protocols:

• The TVL of GLP is significantly higher than that of gDAI, possibly because the returns are higher

• gDAI Users face lower risk because traders' profits are backed by GNS minting, while GMX pays users funds from GLP

• More risk-averse users may be attracted to GLP's high yields, while less risk-averse users can deposit gDAI, albeit with lower yields

The mechanics of Gains Network are similar to GMX’s predecessor, also known as Gambit Financial on BNB. Gambit has generated considerable transaction volume and TVL since its launch. Although Gambit and GMX have similar characteristics in terms of Peer-to-Pool model and revenue sharing mechanism, their parameters are different from each other.

While Gambit gained decent traction, GMX saw a surge in trading volume and user numbers on Arbitrum after revamping its token economics and structure. We noticed the following key changes:

• Distribute most of the proceeds to stakers/LPs

• Gambit only allocated a revenue share of 40% (20% to USDG + 20% to Gambit stakers) to holders/stakers, while GMX v1 allocated a revenue share of 100% (70% to GLP + 30% to GMX stakers)

• Increased the amount of revenue distributed to stakers/LPs, resulting in a good story that appeals to a wider audience than just pure traders

• Transfer risk to LP as direct counterparty

• Gambit only allocates 20%'s revenue share to USDG, while GMX allocates 70%'s revenue share to GLP

• Both USDG and GLP provide liquidity for platform transactions by depositing whitelisted assets. The reason why Gambit provides lower returns to LPs is that USDG is a stable currency, and the platform uses 50%'s share of the returns as collateral to ensure that LPs can exchange funds. Instead, GMX transfers risk to LPs, who bear the brunt of traders’ profits or losses

From the case studies of Gains Network, Gambit, and GMX, we can see that increasing LP returns can incentivize more liquidity relative to the protocol absorbing some risk. In GMX v2, the token economics have been slightly changed, reducing the share of fees for stakers and GLP holders by 10%. Details about this adjustment:

• GMX V1: 30% allocated to GMX stakers, 70% allocated to GLP providers

• GMX V2: 27% allocated to GMX stakers, 63% allocated to GLP providers, 8.2% allocated to protocol vaults, 1.2% allocated to Chainlink, the protocol has receivedCommunityvote to approve

CommunityMembers were mostly supportive in terms of voting and GMX v2’s continued TVL growth, indicating that the change is a positive for the protocol.

Rewarding LPs has many benefits, especially for the Peer-to-Pool model as they are one of the key stakeholders:

• (1) Enhance loyalty to the agreement through stable income

  • Reduce the risk of LPs losing initial capital

  • Combined with stable returns, the inertia of adjusting positions is reduced as they do not need to sell tokens to realize gains

  • For dYdX v3, this mechanism does not apply as the volatility of its native token will be generated upon issuance

• (2) Value accumulation of native tokens

  • For GMX, the growth of GLP and the trading volume on the platform indirectly increase the value of GMX, that is, the fees generated by each token, which is also a huge driver of the demand for the token.

Factors to consider:

• (1) Adjustment LP Risks to the Agreement

  • If parameters are not adjusted based on risk and market conditions, LPs may be exposed to the risks of the Peer-to-Pool and order book models

  • Recently, SNX stakers lost $2 million due to a market manipulation incident on TRB because the OI cap was set in the number of TRB tokens rather than the USD amount

  • In the past, GLP holders have largely benefited from traders' losses, but questions have been raised about the sustainability of the mechanism. As token economics change, any big trader win could be backed by protocol treasury

Our thinking: This mechanism is crucial to the Peer-to-Pool model, as growth requires incentivizing user liquidity. GMX has effectively done this over time through a high percentage of revenue sharing and increasing traders’ losses. While trader wins create risk for LPs, we believe the benefits of mid-sized protocols can more than offset this risk. Therefore, we believe that fully incentivizing LP is very important to build a strong user base.

trade

Transaction rewards are mainly used to incentivize transaction volume, and they are usually issued in the protocol’s native token. Rewards are usually calculated as a percentage of transaction volume/fees of the total rewards planned for a specific period.

For dYdX v3, the total supply used for trading rewards is 25%, which was the main source of distribution during the first two years. As a result, the amount of trading rewards often exceeds the amount of fees paid by traders, meaning that token issuance is highly inflationary. With little incentive to hold (mostly for trading fee discounts), this resulted in DYDX facing significant selling pressure over time. With dYdX v4, this changes, as discussed below.

Kwenta also offers trading rewards to traders on the platform, with a limit of 5% of the total supply. It requires users to stake KWENTA and trade on the platform to qualify. Rewards are determined by multiplying the percentage of KWENTA staked and the trading fees paid, meaning the rewards will not exceed the user’s upfront cost (staking capital + trading fees). Rewards require a 12-month lock-up period. If the user wants to cash out the rewards early, the rewards can be reduced by up to 90%.

Overall, the clear benefits of introducing trading rewards include:

• Incentivize trading volume in the short term:With dYdX v3’s rewards, traders are essentially getting paid when they trade, which helps drive volume growth.

Here are the factors to consider:

• The type of users the protocol wants to attract

  • For dYdX, the ease of qualifying for rewards and the lack of lock-in conditions may attract many short-term users, which dilutes the rewards for real users.

  • For Kwenta, upfront capital and lock-in conditions are required, which may not be attractive to short-term users, which may reduce the dilution of long-term user rewards

Our thinking: Transaction rewards can be an effective way to bootstrap a protocol in the beginning, but should not be used indefinitely as continued token issuance will reduce the value of the tokens. It should also not be a large proportion of the monthly supply and inflation, and staking is important to the protocol to spread the selling pressure.

value accumulation into the chain

Case study: dYdX

The launch of the dYdX chain marks a new milestone for the protocol. On January 18, the dYdX chain even surpassed Uniswap and became the DEX with the largest trading volume.

In the future, we may see more derivatives DEXs follow this pace. The main changes to the coin economics after the dYdX chain update include:

• pledgeis to support the chainSafety, not just to generate revenue

• In v3:SafetyRewards from the pool were issued in DYDX tokens, but were eventually deactivated after the community voted for DIP 17

• In version v4, the dYdX chain requires validators to stake dYdX tokens in order to run and secure the chain. Delegation (staking) is an important process. The staker entrusts the verifier to perform the tasks of network verification and block creation.

• 100% of all transaction fees will be distributed to delegators and validators

• In v3, all generated fees are collected by the dYdX team, which has been a concern for some in the community

• In the v4 version, all fees, including transaction fees and gas fees, will be distributed to delegators (stakers) and validators. This new mechanism is more decentralized and aligned with the interests of network participants

• PoS stakers (delegators) can choose validators to stake their dYdX tokens and receive a share of the revenue from their validators. Commissions for delegators (stakers) range from a minimum of 5% to a maximum of 100%. Currently, according to data from Mintscan, the average validator commission rate on the dYdX chain is 6.82%.

In addition to these changes, new trading incentives ensure that rewards do not exceed the fees paid. This is an important factor as many concerns about v3 focused on inflation and an unsustainable token economic model, which despite subsequent updates had little impact on token performance. Xenophon Labs and other community members have raised questions about being able to "manipulate" rewards, an issue that has been discussed several times in the past.

In the v4 version, users can only receive transaction rewards equal to the net transaction fee of 90% paid by the network. This will improve demand (fees) and supply (rewards) balance and control token inflation. The reward is capped at 50,000 DYDX per day for 6 months to ensure that inflation will not be significant.

Our take: The dYdX chain is at the forefront of the industry’s move toward greater decentralization. The verification process plays a key role on the new chain: securing the network, voting on on-chain proposals, and distributing staking rewards to stakers. Coupled with 100% fees being distributed among stakers and validators, it ensures that rewards are aligned with the interests of network participants.

Value accumulation in liquidity centers

Case Study: Synthetix

Synthetix serves as a liquidity center for multiple perpetual and options exchange front-ends, such as Kwenta, Polynomial, Lyra, dHEDGE. These integrators have created their own custom features, built their own communities, and provided trading front-ends to their users. .

Of all the integrators, Kwenta is the primary derivatives exchange driving the majority of trading volume and fees to the entire Synthetix platform. Synthetix’s ability to capture the value brought by Kwenta and other exchanges is attributed to Synthetix’s token economic model. The main reasons include:

• pledge SNX is the first step to trading on an integrator

• Even with its own governance token, Kwenta only quotes the asset price of sUSD, which can only be minted by staking SNX tokens

• In addition to Kwenta, other integrators such as Lyra, 1inch and Curve (Atomic Swaps) also utilize sUSD and therefore require SNX tokens. Thus, Synthetix’s front-end integrator allows value to be accumulated into the SNX token

• Liquidity Center rewards distributed to integrators

• In April 2023, Synthetix announced the distribution of its massive Optimism token to traders. For 20 weeks, Synthetix will distribute 300,000 OP tokens every week, while Kwenta will distribute 30,000 OP tokens every week.

• From the second quarter to the third quarter of 2023, Synthetix will be able to attract higher transaction volumes and fees. This played a major role in the growth of Synthetix price

It can also be seen from the chart that the total value of SNX pledged has been highly correlated with the price performance of SNX. As of January 22, 2022, Synthetix’s staked TVL is approximately $832 million. They have the highest percentage of staked tokens (81.35%) relative to dYdX, GMX and Gains Network.

Our take: For a liquidity center, relationships should be mutually beneficial. While Synthetix provides liquidity to these integrators, it also receives fees from these integrators, which indirectly drives the trading volume of Synthetix’s TVL. As trading demand for their integrators increases, this will lead to increased demand for SNX, reducing selling pressure and thus indirectly driving up the value of the token. Therefore, working with more front-end integrators will be beneficial to both Synthetix and its token holders.

2. Buyback and destruction

Buybacks can be done by taking a portion of the revenue to purchase tokens on the market, directly driving up the price, or burning to reduce the circulating supply of tokens. This will reduce the circulating supply of the token, as the price is expected to increase in the future as supply is reduced.

Gains Network has a repurchase and destruction plan. Based on gDAI’s pledge rate, a portion of traders’ losses can be used to repurchase and destroy GNS. This mechanism resulted in the destruction of over 606,000 GNS tokens, equivalent to approximately 1.78% of the current supply. Since the supply of GNS is dynamic through its minting and burning mechanisms, it is difficult to determine whether buybacks and burns have a significant impact on the token price. Still, this is one way to offset GNS inflation, which has left the supply hovering between 30-33 million over the past year.

Synthetix recently voted to introduce buyback and destruction in its Andromeda upgrade. The proposal could reignite interest in SNX, as holders are hit both in terms of staking fees and their position in holding deflationary tokens. This reduces the risk of pure staking, as allocations from buybacks and burns can be used as backing for any event, such as what happens to TRB.

The main advantages of this mechanism:

• Ability to control/reduce supply:This ensures that token holders are not gradually diluted as rewards or tokens are issued to other holders

• Users are encouraged to hold tokens:Token holders/stakers gain the added utility of being rewarded for holding a “deflationary” asset

However, the effectiveness of buybacks also depends heavily on:

• Protocol revenue to sustain the importance of destruction: Without a stable income stream, this mechanism will not be sustainable, and its reduced impact may make users lose the incentive to hold tokens.

Our thinking: The burning mechanism may not directly affect the price, but it can promote the idea of purchasing deflationary tokens. This works to a large extent for protocols that generate strong revenue and a large portion of their total supply is already in circulation (e.g. RLB). Therefore, it works for protocols like Synthetix that are already established and don’t have a lot of supply inflation.

3. Token distribution and unlocking plan

Documenting token allocation and vesting schedules for different stakeholders is important to ensure parameters are not biased in favor of certain stakeholders. For most protocols, the primary holder allocation includes investors, teams, and communities. For community tokens, this includes airdrops, public sales, rewards andDAOTokens etc.

The distribution of SNX is calculated based on the increase in token supply due to reward issuance in February 2019 monetary policy changes

When looking at the allocation and unlocking plans for these protocols, we came to a few conclusions:

• GMX and Gains Network are the exceptions in raising funds solely through public sales of tokens. “Community-owned” protocols can reduce users’ concerns about investors, incentivizing them to hold tokens and participate in the protocol

• Both dYdX and Synthetix have large supplies reserved for investors, at 27.7% and 50% respectively (before the supply change). However, dYdX has a long lock-up period of about 2 years, while Synthetix has a 3-month lock-up period after TGE and unlocks quarterly after that

• Both GMX and Gains Network are converting from another token to the current token, meaning the majority of the supply has already been unlocked at launch. This means that further releases of future rewards will represent a very small proportion of the circulating supply.

• Both dYdX and Synthetix reserve large supplies (>=50%) for rewards. However, dYdX rewards are pure issuance, while Synthetix distributes a portion of fees + rewards that are unlocked over 12 months. This reduces SNX inflation compared to DYDX

Because the holders and mechanisms adopted by different protocols vary greatly, there is no clear formula for token distribution or unlocking. Nonetheless, we believe the following factors will generally benefit token economics for all holders:

• The community should allocate the most tokens

• The team’s token allocation should not be excessive and the unlocking schedule should be longer than the majority of holders as this may indicate their belief in the project

• Investors should have minimal token allocation and long unlocking time

• Token releases should be spread out over a period of time and include some form of lock-up to prevent significant inflation at any point in time

4. Governance and Voting

For derivatives DEXs, governance is very important because it gives token holders the power to participate in the decision-making process and influence the direction of the protocol. Some of the decisions that governance can make include:

• Protocol upgrades and maintenance

  • Derivatives DEXs often require upgrades and improvements to improve functionality, scalability, and growth. This ensures the protocol remains up to date and competitive

  • For example, in GMX’s most recent snapshot, governance approved proposals to create a BNB market and GMX v2 fee distribution on GMX V2 (Arbitrum)

• risk management andSafetysex

  • Token holders can collectively decide on staking requirements, liquidation mechanisms, bug bounties, or emergency measures to be taken in the event of a breach or exploit. This helps protect user funds and build trust in the protocol

  • Synthetix recently suffered a $2 million loss due to TRB price fluctuations. This highlights the importance of ongoing review of parameters – adding volatility circuit breakers and increasing sensitivity to skew parameters pricing in volatility spikes

• Liquidity and user incentives

  • Token holders can propose and vote for strategies to incentivize liquidity providers, adjust fee structures or introduce mechanisms to enhance liquidity provision

  • For example, dYdX’s governance has passed the v4 launch incentive proposal

• Transparent decentralized community

  • Governance should build decentralized communities with transparency and accountability. Publicly accessible governance processes and on-chain voting mechanisms provide transparency into the decision-making process

  • For example, DEXs like dYdX, Synthetix, GMX adopt on-chain voting mechanisms to promote decentralization

Our take: Through governance, it helps create a strong and inclusive community for stakeholders involved in derivatives DEX. Having on-chain voting mechanisms and transparency in decision-making builds trust between stakeholders and the protocol because the process is fair and accountable to the public. Therefore, governance is a key feature of most cryptographic protocols.

try new mechanics

In addition to the above factors, we believe there are many innovative ways to introduce additional utility and incentivize demand for the token. Protocols need to prioritize the introduction of new mechanisms based on the stakeholders they target and what is most important to them. The table below shows the key stakeholders and their main concerns:

Given the variety of concerns, it is impossible to cater to all stakeholders. Therefore, it is important for a protocol to reward the right group of users to ensure continued growth. We believe there is scope to introduce new mechanisms that can better balance the interests of different stakeholders.

in conclusion

In summary, tokenomics are a core part of crypto protocols. There is no clear formula for determining successful tokenomics, as there are many factors that can affect performance, including factors beyond a project’s control. Nonetheless, the crypto market is rapidly changing and constantly changing, which highlights the importance of reacting with flexibility and adjusting to market conditions. From the examples above, you can see that trying new mechanisms can be very effective in order to achieve exponential growth.

The article comes from the Internet:DWF Labs Research: Deep dive into the economic model of on-chain derivatives exchanges

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