One of the most successful DeFi protocols, dYdX, plans to develop a new version using Cosmos SDK. It has been a while for the Cosmos ecosystem to have any good news. This article will be divided into three parts. Firstly, an introduction to dYdX and its current limitation. Second, an update on Cosmos after the collapse of Terra. Third, what’s the implication of dYdX moving to Cosmos to both dYdX and Cosmos ecosystem.
Introduction to dYdX
dYdX is an order book decentralized exchange focusing on derivatives products, mainly perpetuals. The protocol v1 version was originally built on Ethereum mainnet. Due to the high gas cost and performance limitation of Ethereum, the protocol launched Ethereum Layer-2 version built on StarkEx. On L2, the protocol can offer very low fees with no gas costs, together with instant transactions and instant withdrawals.
The transition to StartEx was proved to be a successful strategy. Its transaction volume for major trading pairs such as $BTC-$USD and $ETH-$USD can be as competitive as to major established exchanges. According to data compiled by Messari, the protocol’s trading volume for $BTC perpetuals was nearly the same amount as Derbit and BitMex in 2022 Q1. For $ETH perpetuals, dYdX’s volume came in third place just behind Binance and FTX in Q1.
The governance token of dYdX is $DYDX. Since the launching of the token in 2021, the token price has been on a downward trend even before the general bear market started in early 2022.
One of the reasons for the poor price performance despite the good traction of the protocol is the lack of utility. The protocol token is just a governance token, and the only one other benefit to holding the token is to enjoy some trading fee discount when using dYdX.
Current Design of dYdX
While most DEX protocols currently utilized the AMM (automatic market maker) model, this model operates with passive liquidity provision and is not suitable for high-frequency trading activities such as perpetual trading.
On the other hand, the traditional financial market predominantly uses an orderbook design. Traders submit bids and offer prices and trades are matched by the orderbook. To operate the order book market requires a sheer magnitude of transactions and computation and thus makes it impossible to operate on a gas-expensive chain like Ethereum.
To increase transaction speed and reduce gas cost, dYdX now builds its own Layer-2 using StarkEX technology powered by Starkware, a ZK-rollup scaling solution for Ethereum. The transactions are aggregated via ZK (zero-knowledge proof) rollups, executed off-chain, and then upload to Ethereum mainnet for finality. Zero-knowledge proofs generate cryptographic proofs to prove the validity of transactions, and each batch of transactions comes with a “proof of validity” when it is uploaded to Ethereum mainnet.
dYdX currently maintains an order book and matching engine off-chain with settlement happening on-chain. The actual matching of orders happens on a central server. According to the team, even layer-2 solution cannot support the speed dYdX requires to run a fully on-chain order book and matching engine.
While Serum on Solana does build the order book exchanges on-chain, we all know Solona chain is more centralized and hence allows for higher speed. dYdX wants to achieve higher transaction processing speed while ensuring decentralization, which is very difficult.
Cosmos ecosystem was hit hard by the collapse of Terra. As $UST had been the single most used stablecoin in Cosmos ecosystem, and Dexes such as Osmosis used $UST as the base currency for most trading pairs.
There is still no sign of recovery yet. Osmosis is currently the most active app-chain in the Cosmos ecosystem. Its TVL has dropped to $170 million from $1.75 billion, the highest point in April.
The only notable development is the emergence of Axelar, a cross-chain bridge connecting with the Ethereum system. Through Axelar, the Cosmos ecosystem has started to onboard $USDC & $DAI for use in the ecosystem.
A dYdX Chain in Cosmos
The main benefits of an independent chain built on Cosmos can be summarized into two aspects:
Achieve High Speed and Decentralization
An independent chain will have its own validator set and is more flexible in the chain design. According to dYdX’s announcement, it will design the structure that each validator will run an in-memory order book. Orders placed will be propagated through the network similar to normal blockchain transactions. And the orders will be matched together by the network. In this way, decentralization is achieved through a diverse set of validators. (Check the section ‘Off-chain, decentralized, orderbook+matching’ in the announcement)
As discussed in the prior section, $DYDX doesn’t have much value accrual mechanism in its current design. In Cosmos ecosystem, every app-chain is responsible for its own security, which means each chain has its own chain native token and conducts its own consensus mechanism. $DYDX will be the native token of the app-chain, which needs to be staked by validators and be used as the gas fee payment. A layer-1 native token naturally has more functions than a pure governance token.
$DYDX Market Cap. and Chain Security
Currently, $DYDX has the market cap. of $100m and FDV of $1.5b. Transforming from a protocol to an independent chain doesn’t mean it will have a higher market cap. In that case, the security issue of the PoS chain should be taken seriously.
Being a protocol on Ethereum Layer-2, the protocol itself face no blockchain security issue. Layer-2’s security is dependent on Ethereum. In its current form, Ethereum is a Proof-of-Work blockchain, the consensus mechanism is maintained by miners. However, an independent chain built with Cosmos SDK is a Proof-of-Stake blockchain, the consensus mechanism is maintained by validators who lock native tokens to perform transaction validation. dYdX needs to bootstrap its own validators set, and the chain’s security is a function of the decentralization of validators and the chain’s native token’s total market capitalization.
With a TVL of around $700M, but a market cap. of only $100 million, $DYDX doesn’t seem to be eligible to secure a 7x TVL.
Interchain Security by Cosmos Hub?
In the article “Cosmos Hub & $ATOM — What’s Their Role in The Cosmos Ecosystem’, we discussed how Cosmos Hub and $ATOM could help to secure the other app-chain in the Cosmos ecosystem through the upcoming interchain security function so that a small app-chain could gain the security from validators from $ATOM stakers. In the case of a potential dYdX chain, dYdX could use this function and be secured by the full validator set and multi-billion dollar market cap of the Cosmos Hub.
Ethereum layer-2 and the future Ethereum 2.0 will improve performance, however, the general consensus is it will still more focus on security rather than speed. Solana is ultra-fast and hence is suitable for high-frequency trading platforms. dYdX wants performance and flexibility, a sovereign app-chain is a natural choice.
Multi-chains narrative has been fading a little bit in this bear market, and the market share for Ethereum recovered from around 50% to 60% in terms of TVL. But I still believe in a multi-chain future, protocols with different characteristics will choose different chains. For low frequency, high-value use-case such as lending & borrowing will stick to Ethereum. For others, like web 3 products, the performance and speed are more important will choose sidechains like Polygon or Alternative layer-1 like Solana. Some more successful application protocols may choose to establish application chains to make the future development space more flexible.