What’s behind dYdX’s explosive growth and skyrocketing revenue?

Derivatives exchange dYdX is proving to be one of the first success stories on Ethereum’s layer two. 

On September 30, the exchange crossed $70 billion in all-time trading volume. In recent days, its trading volumes have exceeded other centralized derivatives exchanges like BitMEX. And, in total, it has made more than $40 million in revenue since it launched.

Messari analyst Ryan Watkins points to data from Token Terminal that shows it has generated more revenue than any other DeFi protocol. “It’s not even close.” 

What's behind dYdX’s meteoric rise? One factor is the novel technology under the hood. But it’s undeniable that the healthy dose of incentives the platform’s developers introduced have sweetened the deal. 

What is dYdX?

dYdX is one of the first decentralized derivatives exchanges. That means it enables people to place short and long bets on the prices of various cryptocurrencies against other traders without any intermediaries. It is also non-custodial, meaning that traders hold their funds in their own wallets as opposed to depositing them with a centralized exchange to trade.

Behind dYdX is a company called dYdX Trading, located in San Francisco. The company launched the exchange in April last year. A year later, it opened the door to derivatives trading on Ethereum’s Layer 2.

Layer 2 is a general term that refers to a number of technological approaches to processing cryptocurrency transactions in a cryptographically-secure environment separate from the main blockchain. By not having to rely on Ethereum to process these transactions, they can be executed faster and more cheaply.

The specific Layer 2 platform that dYdX runs on is known as StarkEx. Developed by Israel-based startup StarkWare Industries, StarkEx uses zk-rollups, which allow it to process thousands of transactions per second. Every hour, a cryptographic proof of these transactions is uploaded onto the Ethereum blockchain, making sure the transactions are secure.

The dYdX token and incentives

The integration of StarkEx made the exchange more attractive to traders. But it wasn’t until dYdX launched its governance token that it truly took off.

In August, the dYdX foundation airdropped dYdX tokens to all early adopters of the project, depending on how much they had used the exchange. The majority of users received 1,163 dydx tokens, which are currently worth $26,700.

With this token, the platform started offering incentives for people to use the exchange. Tokens are distributed to those who provide liquidity, in order to encourage market makers to join the network. Plus, those holding the dydx tokens can now receive trading fee discounts, and the more they hold the larger the discount. 

These incentives were what really kickstarted dYdX’s growth. While dYdX was doing around $200 million in weekly volume in July, that shot up to $1.1 billion in August. Last week it saw $30 billion in volume.

There have been a couple of peaks though. For the first two weeks of August, the exchange had nearly 9,000 weekly active traders, a number that has since declined and now sits at around 6,000 per week.

Trading volumes had big spikes in late September too, seeing around $9 billion in trades per day for two days. But by September 30, this dropped back to around $2 billion per day.

Can it keep this up?

With such crazy volumes and high volatility, one important question is whether dYdX is seeing sustainable growth — or if it’s just riding high on the incentives.

“I do think it’s sustainable but I don’t know if it will continue to do $10 billion a day,” says Watkins. While many other projects have issued similar incentives, few have taken off in the same way, he says.

Watkins says that it’s the emergence of layer two platforms that has enabled dYdX to catch hold, since its performance today would simply not be possible on Ethereum’s main blockchain layer (which can only handle 13 transactions per second). But with new layer two platforms, such as Arbitrum, there will be more decentralized derivatives exchanges launching soon that could provide competition, says Watkins. He names Perpetual Protocol and MCDEX among them.

“Maybe the pot is just growing. I think these decentralized venues will take share from centralized venues. It’s not like dydx will be turning off the incentives any time soon,” he says.

What else could be driving this growth?

Another element that could be behind the surge of attention toward dYdX has been the cracking down on centralized derivative exchanges in the U.K. and elsewhere around the world. There has also been a general ban on crypto trading in China, leading exchanges Huobi to stop servicing Chinese residents.

“These decentralized venues are increasingly becoming one of the best ways for people to access some of these assets they want to trade,” says Watkins.

Despite the idea that dYdX could be a way to access derivatives exchanges where such trading is illegal, the exchange is trying to stick within the rules. For example, U.S. traders are not permitted to use the service.

Uri Kolodny, CEO of Starkware — which builds the layer 2 solution that dYdX uses — says that dYdX blocks U.S. residents and that it’s “very careful to abide by any and all regulatory requirements as are we.”

At the same time, however, Starkware is decentralizing its services, which will mean dYdX will soon be running on a more decentralized network — one that won’t require identification to participate at the network level. Kolodny says it will remain up to dYdX as to how it chooses to comply with regulators once that happens.