Building a Successful DEX Pt 2: Protocol Analysis

Defillama lists Uniswap V2 as the most forked protocol in crypto with an astonishing 425 forks and Solidly as the 5th most forked protocol with 35 forks.

When we set out to build Pearl, we wanted to learn as much as we could about building a successful DEX from the graveyard of DEXs. Here’s what we learned.

INNOVATION MATTERS

Firstly let’s pay homage to the King: Uniswap is 40% of the total DEX volume at the time of writing this. Uniswap introduced the on-chain automated market market (AMM) to the world when it launched in November 2018. The core Uniswap values, many of which are shared with Ethereum, remain central to DEX builds today. This includes secure, permissionless, censorship-resistant access to decentralized asset exchange.

The innovations deployed in Uni v2 and Uni v3 have cemented it as the clear market leader.

V2 really created the modern AMM as we know it, introducing the ERC20/ERC20 liquidity pools. V1 required each pool to include ETH as one side to the pair. As seen above, v2 established the template which nearly every DEX to follow has built on.

V3 introduced many new features, addressing pain points and optimizing towards a more fluid and efficient AMM. Concentrated liquidity being the most widely recognized innovation in Uni v3.

Uniswap is the undisputed market leader, a fact that’s unlikely to change any time soon. It will be often imitated, but never duplicated.

INCENTIVES MATTER

Incentive alignment is a fundamental driver to activity in crypto. Nothing moves forward unless everyone has something to gain from it. Curve has clearly proved this point through their creative use of incentives to drive TVL.

Curve barely does 10% of Uniswap’s daily volume but has +$1B more in TVL. How have they pulled this off? Curve incentivizes liquidity providers on the protocol with CRV emissions, Curve’s governance token. Users can earn incremental rewards for providing liquidity, above and beyond swap fees.

Our article on the history of bribing digs into Curve’s incentive game in much more detail for interested readers. And our bribing analysis post shares a summary of it’s effectiveness.

UNDERSTANDING THE DEATH SPIRAL

If protocols are unable to innovate on core AMM curve design like Uniswap, it stands to reason that to compete they must deliver better incentives. You can read more on our approach to incentives in our article on The Pearl Flywheel. It’s within this topic of incentives where we can learn the most about why some new DEX, specifically those using the Solidly model, have succeeded while others have failed.

It’s our opinion that all failed Solidly forks fail for one core reason: they are unable to attract sticky bribers. This is contrary to common belief that they fail because they are unable to attract sticky liquidity.

Let’s examine Solidly model tokenomics to better understand this concept:

Solidly forks emit governance tokens for the DEX at a highly inflationary rate as rewards for early liquidity providers with the emissions designed to tail off over time. The general idea is that these governance tokens will become more valuable as the DEX establishes itself, with swap fees accruing to locked token holders. Locked token holders also take in their share of protocol bribes, as explained here.

The death spiral occurs when the market loses faith that the DEX governance token will have any value in the future. This leads to a decrease in the value of emissions (token worth less, emissions worth less, APR falls) causing mercenary LPs to leave with their funds. Projects that aren’t aligned with the DEXs long term success begin to reduce their bribes, resulting in less users locking tokens to receive fees and bribes, which results in more token selling, accelerating the spiral to the graveyard.

So many new DEXs all seem to follow this same pattern:

• Initial excitement as token launches
• Low float and high inflation make emissions valuable for a few weeks
• Inflation eventually outpaces token demand
• LPs rush to the exits

Sadly this outcome is entirely predictable. And realistically, how many DEXs do we really need, when they all do essentially the same thing? Solidly Summer is quickly becoming solidly overdone.

So if all these forks are doomed to fail what makes Pearl different? What have we learned to ensure our success?

Explore these answers in the Pearl flywheel… which we’ll cover in our next article.