The decentralized derivatives trading platform dYdX achieved a significant milestone just six months after launching its Layer 2 protocol: its daily trading volume surpassed that of Coinbase. Remarkably, it accomplished this by offering perpetual contracts for only four assets. Today, dYdX stands as one of the most liquid exchanges in the cryptocurrency space. It has expanded beyond its initial offerings and now supports 28 markets, doubling down on its focus on perpetual contracts.
How did a non-custodial, decentralized exchange with only a handful of markets outperform more established, fully centralized exchanges with extensive market offerings?
When it comes to Ethereum scaling solutions, developers often face a trilemma: they must choose two out of three desired attributes—decentralization, composability, or performance (measured in transactions per second, latency, and gas fees). Composability requires compatibility with the Ethereum Virtual Machine (EVM) to enable interoperability with other EVM-based decentralized applications. Performance demands either reducing the number of validators (thus compromising decentralization) or adopting zero-knowledge (ZK) technologies, which currently are not fully EVM-compatible. Decentralization typically necessitates opting for a rollup solution. Each approach involves trade-offs.
Large-scale scaling efforts began with platforms like Binance Smart Chain (BSC), followed by others such as Polygon and xDAI. These platforms operate as Ethereum-compatible sidechains, offering high speeds and low gas fees. Essentially, they use delegated proof-of-stake mechanisms to reduce the number of validators securing the network, enabling faster consensus. For example, BSC uses 21 whitelisted validators in its “proof-of-stake” system, while Polygon employs 100 validators in a standard delegated proof-of-stake model.
dYdX chose to prioritize performance and decentralization over composability. Powered by StarkWare’s StarkEx platform, dYdX features code that is customized and optimized for its specific needs. As a true rollup, it maintains full decentralization. However, this requires writing code in Cairo, a language specific to ZK-proof systems, rather than in an EVM environment like Optimistic Rollups.
Understanding Perpetual Contracts
A perpetual swap is a derivative product similar to futures, designed to track the price of an underlying asset. It is a synthetic instrument that uses a periodic “funding” mechanism to peg its price to the spot price of the underlying asset. First popularized by BitMEX and based on the concept of perpetual futures proposed by economist Robert Shiller, these contracts are now the most popular type of derivative in the cryptocurrency market.
How Do Perpetual Contracts Work?
Unlike traditional futures contracts, which obligate the buyer to purchase or sell an asset at a specific future date and price, perpetual contracts use a funding rate mechanism to align with the spot price without requiring physical settlement or holding the actual asset.
Traders can take either long or short positions. To help users price these instruments, dYdX provides two reference prices:
- An index price aggregated from multiple exchange APIs, managed off-chain to prevent update delays and slippage.
- A fully decentralized oracle price, aggregated using multiple on-chain oracles. This price is used for calculating margin and collateral for liquidation.
Every hour, dYdX compares the prices of long and short positions to the index price. Those on the wrong side of the price movement pay funding to those on the right side. This creates a powerful mechanism that keeps the perpetual contract price in sync with the spot price, as any discrepancy presents an arbitrage opportunity.
Like futures, these instruments can be traded with leverage.
This mechanism, initially proposed by Shiller, was designed to improve efficiency in illiquid markets. Today, thanks to the trading volume and speed on centralized exchanges (CEXs) and decentralized exchanges (DEXs) like dYdX, perpetual markets are more liquid and active than many decentralized spot markets. Moreover, because these are synthetic assets, trading volume can far exceed the actual circulating liquidity of the underlying asset. The trading volume of these futures is limited only by open interest. As a result, the reference price of the underlying asset is often determined by the perpetual market rather than the spot market.
This year, the crypto derivatives market has surpassed the spot market in trading volume, a trend that continues to grow.
dYdX’s Rapid Rise in Open Interest
dYdX has quickly climbed the ranks in terms of open interest. While it currently supports only 28 markets, compared to Binance’s 90+, its focused approach has proven effective.
Given the complexity of perpetual contracts, this market is not typically suited for the average retail trader. Cross-margin requirements involve sophisticated risk management, and details like funding rates, interest rates, and premiums make it a domain for professionals.
dYdX has around 45,000 depositors, most of whom are professional traders, institutional players, and market makers. As with any liquid market, the majority of trading volume is driven by active market makers.
Monthly snapshots reveal that nearly 90% of the volume is generated by about ten market makers.
The Role of the DYDX Token
The explosive growth in trading volume is not only due to the high performance enabled by dYdX’s Layer 2 protocol but also the introduction of the DYDX token.
The DYDX token was launched by the dYdX Foundation, not the dYdX trading platform, which is a for-profit company. The company is working to decentralize all aspects of the exchange and transfer full control of the protocol to the foundation.
Earning Rewards with DYDX
Users can stake USDC to earn DYDX rewards. dYdX maintains a liquidity pool where community-approved liquidity providers market-make on the platform. These makers borrow from the pool and must repay the funds if their balance falls below the allocated amount for each period. By staking USDC in these pools, users earn DYDX. Additionally, dYdX has a USDC safety pool that acts as an insurance fund, distributing DYDX tokens to stakers.
Trading rewards are also distributed to all traders based on a formula designed to boost the adoption of the Layer 2 protocol, increase liquidity, and enhance activity.
Governance with DYDX
DYDX holders have the right to propose and vote on changes to the protocol. Several important proposals have already passed, including one from Three Arrows Capital CEO Su Zhu. This proposal aimed to reduce incentives for market makers in response to growing liquidity in the financial system. More recently, another proposal allowing the recovery of the safety module, DIP 3, was approved. The enactment of these proposals demonstrates that token holder governance is functioning effectively on dYdX.
dYdX vs. Perpetual Protocol
Perpetual Protocol, built on the xDAI sidechain, is another high-performance, non-custodial perpetual swap trading protocol. In contrast to dYdX’s central limit order book model, Perpetual Protocol uses a virtual automated market maker (vAMM)—a smart contract-driven trading system that does not require a counterparty to execute trades, similar to Uniswap’s AMM. However, unlike Uniswap, because perpetual contracts are synthetic, there is no need to hold the underlying asset in a pool.
The vAMM design means that trades may experience price slippage upon execution, and throughput is slightly lower compared to dYdX. On the upside, there is no auto-deleveraging when a counterparty is liquidated. Like dYdX, all trades are settled in USDC, and no gas fees are charged for transactions.
In essence, dYdX focuses on performance and parity with centralized exchanges, while Perpetual Protocol emphasizes guaranteed liquidity via its vAMM without relying on market makers. This expands its use cases, such as in private markets. Comparing the two highlights the fact that this is a large design space still being explored, and the numerous choices and trade-offs involved can lead projects down different paths. So far, these design choices appear to favor dYdX in terms of trading volume.
The Path Ahead for dYdX
dYdX’s adoption and trading volume are on a steep upward trajectory. While there is still a long way to go to achieve its goal of becoming the “largest” exchange, the outlook is promising. The current focus is on increasing the number of markets while maintaining a strong emphasis on perpetual contracts and completing the transition to full decentralization.
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Frequently Asked Questions
What are perpetual contracts?
Perpetual contracts are derivative products that track the price of an underlying asset without an expiration date. They use a funding mechanism to stay aligned with the spot price and are popular in crypto markets for their flexibility and leverage options.
How does dYdX achieve high performance?
dYdX leverages StarkWare’s StarkEx, a Layer 2 scaling solution that uses zero-knowledge proofs for validation. This allows for high throughput, low latency, and reduced gas fees while maintaining decentralization.
Can retail traders use dYdX effectively?
While possible, dYdX is primarily designed for professional traders due to its complex features like cross-margin trading and funding rate mechanisms. Retail users should have a solid understanding of derivatives before participating.
What is the utility of the DYDX token?
The DYDX token is used for governance, staking, and earning rewards. Holders can vote on protocol upgrades, stake USDC to earn yields, and receive trading incentives.
How does dYdX compare to centralized exchanges?
dYdX offers a non-custodial, decentralized alternative to centralized exchanges with similar performance levels. It provides users with full control over their funds while supporting high-speed, high-volume trading.
What assets are supported on dYdX?
As of now, dYdX supports 28 markets, primarily focusing on major cryptocurrencies like Bitcoin, Ethereum, and others through perpetual contracts.