Last week, dYdX announced that they were moving away from Ethereum and building their own chain. Here’s their announcement.

In this week’s deep-dive, we’re going to dive into their decision and the motivations for building your own chain. We’ll look at:

Centralised exchanges (Coinbase, FTX) act as the intermediary between buyers and sellers. They make money by taking a percentage of trading fees.

Decentralised exchanges (Uniswap, dYdX) facilitate trades directly between buyers and sellers. There is no intermediary.

There are 3 key advantages of a decentralised exchange:

Market making is the process of facilitating the buying and selling of an asset. Decentralised exchanges use two approaches for market making:

An order book is a list of prices that participants are willing to buy and sell at. The screenshot below is the order book for Bitcoin in GBP terms from Coinbase’s platform.

The market price is determined based on this data. In the example above, it is £17k for 1 BTC.

Automated market making

Automated market making involves aggregating liquidity for the two assets being traded and determining a price using a formula. Decentralised exchanges run this calculation on smart contracts.

In the example above, I’m trying to swap two assets: 1 ETH (Ethereum’s native token) for 1 UNI token (native token for the Uniswap exchange). Uniswap maintains a pool of ETH, a pool of UNI and determines a price using a formula based on the quantity of those two pools. Participants who provide liquidity for either the ETH or UNI pools are rewarded.

Key call outs

Order books and automated market making have their respective pros and cons. The most relevant ones for this discussion are:

If you’re interested in learning more about these approaches, I recommend reading this article.

dYdX is a decentralised exchange focussed on perp trading. Perp trading involves using debt to make leveraged trades. The debt does not have a fixed term — hence the name “perp” (stands for perpetual). Here’s a quick example to explain how it works:

As you can see, you can lose more than you invest. This is why I strongly recommend against leveraged bets unless you know what you’re doing. Read last week’s deep-dive on the curse of leverage for more info.

Due to its focus on perp trading, dYdX will always have fewer traders than other platforms — perp trading isn’t for everyone.

If dYdX used an automated market making method, the price of assets are likely fluctuate a lot because of limited liquidity pools. Given its focus on leveraged trading, this could lead to margin calls (i.e. when the price of a security hits a threshold, the lender asks for their money back). Therefore, dYdX has to rely on an order book method.

dYdX is moving from Starkware, an L2 on Ethereum, to its own chain.

An order book requires a lot of data storage. Given prices are determined constantly quotes, there is a need to save a lot of data on a continuous basis. Blockchains are not great for data storage.

dYdX’s current solution uses Starkware. Starkware is an L2 solution on Ethereum. L2’s aggregate data off the main blockchain (Ethereum), process it and then submit an aggregate transaction to the main blockchain (Ethereum). They trade some amount of decentralisation for the ability to process large amounts of data.

dYdX’s L2 approach allows it to store large amounts of data and significantly reduce gas fees (transaction fees when you interact with a blockchain).

If a system is working, why change it? The move is motivated by:

We discussed the data requirements, let’s look at the requirements for decentralisation.

One of dYdX’s core objectives is decentralised. I’ve always said, and will continue to say, that decentralisation means nothing to users. It’s a tool that could unlock benefits for users.

In the case of dYdX, I believe this benefit is regulation. The current approach requires that dYdX aggregate transactions and then submit them to Ethereum. Authorities like the Bank of International Settlements and the CFTC have often said DeFi protocols are not as decentralised as they seem. dYdX doesn’t operate in the US at all, likely because of this.

The move to an independent chain might help achieve the level of decentralisation it needs to satisfy authorities and the requirements for processing large amounts of data. They’re building the chain on the the Cosmos ecosystem, an ecosystem that allows people to easily spin up their own blockchain.

Using dYdX’s example, let’s look at the pros and cons of building your own chain:

Pros

Cons

Personally, I understand the reasons for dYdX’s move to build its own chain. I hope they can do it, but remain cautious because of concerns around security and cross-chain bridges.