O P T I M I S M 🔴✨

Part 1: On DEXs

A thread on our first installment of our Mirror articles:

Part 1: On DEXs

A thread on our first installment of our Mirror articles: https://bit.ly/3WDgEaU

What DEXs Do

Permissionless Market Creation: Users can create markets for various tokens without gatekeepers.

Always-On Liquidity: DEXs provide continuous liquidity for other DeFi protocols, enabling programmatic interactions.

Enable Token Swaps and Price Discovery.

The central trading and liquidity marketplace on @optimismFND

velodrome.finance 


What DEXs Need

Liquidity Providers. LPs supply assets for trading, earn fees, but require compensation for impermanent loss risk.

DEXs must attract LPs to ensure low-slippage trades and competitive execution.

Bootstrapping liquidity is a problem all DEXs face.

Uniswap: The First Superstar DEX

Uniswap pioneered two key models:
• vAMM: Allows price discovery across infinite ranges.
• Concentrated Liquidity (V3): Lets LPs define specific price ranges for liquidity provision, enhancing capital efficiency.

LP Compensation:

Uniswap charges trading fees and directs 100% of them to LPs. In effect, LPs have to produce their own returns; they earn their share of whatever is generated by the protocol as they participate.

Limitations of Uniswap's Approach:

LPs' earnings are capped by trading volume.

The model is vulnerable to liquidity mining by competitors like SushiSwap, which offers bonus tokens to LPs on top of fees.

The Downward Spiral Risk:

Uniswap’s fee structure makes LPs sensitive to the platform's trading volume. If LPs leave for better opportunities, trading volume decreases, leading to lower fees and further LP exits—a potentially damaging downward spiral for the protocol.

Disproportionate Value to LPs:

Uniswap has generated around $1B in annual fees, all going to LPs. This distribution model may not sustain long-term alignment from all stakeholders, including developers and investors, who are increasingly demanding a share of the generated value.

Uniswap Labs' Revenue Challenges:

To address this, Uniswap Labs has introduced front-end fees for users making swaps on their platform. This means users now face two layers of fees: one for LPs and another for Uniswap Labs, raising concerns about the overall cost to traders.

Governance:

Uniswap operates as a "headless" protocol, as LPs solely benefit from its use. This leaves significant value on the table for other stakeholders, e.g. developers, projects seeking liquidity. Effective governance is lacking, making it difficult to steer the protocol.

The UNI Token is Near Useless:

The UNI token was introduced to incentivize LPs and fund Uniswap Labs, but it has struggled to provide value to holders. Without a fee switch, UNI remains limited in utility, leaving the DEX economy directionless and vulnerable to competition.

UNI Token:

The Uniswap Foundation has sold around $60M UNI to fund operations and supports the grants program. However, without activating the fee switch, UNI's value remains limited, creating a zero-sum scenario where increasing fees for UNI holders means less for LPs.

Curve Finance: A Decentralized, Autonomous Business

Curve emerged as a game-changer in DeFi with its focus on stablecoin swaps. Its innovation didn't stop there—it evolved to become a fully decentralized, autonomous business. Let's dive into how Curve's innovations set it apart.

Real Governance & Value Accrual:

Curve's economics include enhancing the utility of its native token, CRV. By allowing CRV holders to receive a share of the fees, Curve solved the issue of capped LP earnings and introduced a novel revenue share mechanism.

veCRV: A Token You Can Run a Business On:

veCRV is a stakeholdership mechanism that aligns incentives with the protocol's success. Tokenholders lock CRV for a period, gaining a share of the fees. Launched in 2020, this commitment has created many diehard Curve fanatics.

Voting and Incentivization Optimization:

Curve tries to solve the classic dilemma—how to direct liquidity to the most useful pools. veCRV voters direct CRV emissions, under the assumption pools with real market demand are funded, thus optimizing the DEX and its liquidity.

New Revenue Streams:

A breakthrough came when Curve realized veCRV votes were valuable. This led to the creation of a vote incentive marketplace, attracting capital from new stablecoin issuers and significantly boosting the ecosystem. The "Curve Wars" showcased this potential.

Issues:

Despite its success, Curve faces challenges. The "Curve Wars" exposed vulnerabilities, such as hostile takeovers and centralized control by a few entities. This has created friction within the ecosystem and affected its sustainability.

Centralization Risks:

Protocols like Convex Finance, which made veCRV liquid, also introduced centralization risks. These new players fragmented the community and shifted control away from original veCRV holders, impacting incentive alignment and user experience.

Risk of Captured Value:

Just as Uniswap LPs face capped earnings, veCRV holders risk seeing outside teams capture an outsized portion of value through derivative yield products. This leaves an opportunity for a new entrant to offer a strictly better deal to tokenholders.

Principal-Agent Issues:

When core contributors become wealthy early in a protocol's life, they often sell large token allocations, diminishing their incentive to innovate. This can lead to a lack of attention to emerging competitors and missed market opportunities.

Where are we now?

Uniswap and Curve have dominated the DEX space for years, each facing unique challenges in sustaining long-term participation. Both platforms struggle with capped user value distribution, limiting earnings for LPs and tokenholders, and competitor offers.

Community Engagement Limitations:

Uniswap's economic activity is driven by market forces, with limited community involvement from the Uniswap Foundation. Similarly, Curve's community is fragmented across derivative protocols, leading to alignment and growth challenges.

A DEX with a wholly aligned set of contributors focused on long-term sustainability, rather than token sales, could achieve a new class of DeFi infrastructure. The next installment will discuss the MetaDEX as the result of this approach. Here's what the @base team thinks.