If you were in New York last week for the Mainnet conference and asked anyone you met to name the most admired companies in the cryptocurrency category, they’d likely mention an exchange. If you took a 10-minute cab ride to Wall Street and asked the same question about traditional finance, the answer would probably be a bank.

One of the curiosities of cryptocurrencies is that centralized exchanges are at the apex on almost any dimension: profits, use, stature and (yes) innovation (e.g., perpetual swaps, a type of derivative pioneered in crypto). DEXs, their decentralized counterparts, have contributed innovations like automated market makers (AMMs).

But so far DEX volume is a sliver of CEX volume — they are less-known, used by fewer and profits are nearly nonexistent: most protocols pay out in rewards more than they generate in fees.

The perpetual-swap exchange dYdX is an exception on that last point (profits). And yet, it hasn’t added a market pair since 2022 and its liquidity and listings are far behind the largest centralized derivatives exchanges. In the world of Web3 and decentralized finance (DeFi), product-market fit is hard to find. How does dYdX do it?

Recently, dYdX announced a partnership with Axelar (where I have a role on the core team): it is rolling out version four (v4) of the exchange on a dedicated blockchain they are building with Cosmos SDK and Axelar is providing cross-chain infrastructure to onboard users and collateral deposits from other chains. That rollout is expected within the next month or two.

Learning more about dYdX gave me a fresh appreciation for what it’s delivered to users. I asked dYdX founder Antonio Juliano and spoke with multiple dYdX users to learn about the product decisions that have driven user adoption. Here’s what I found.

This article originally appeared on coindesk.com. Thanks to the editors there for their help improving it.

Background: Perp-swaps and dYdX v3

The perpetual swap (aka “perp-swap,” or just “perp”) is a derivative invented by the cryptocurrency exchange BitMEX. It’s like a futures contract, but instead of a maturity date it pays out funding rates periodically, usually every eight hours. Its popularity drove BitMEX’s rise starting in 2017 and ushered in a new class of professional cryptocurrency traders. (The rise of perps wasn’t all smooth: In 2019, I analyzed some of the systemic risks and flash crashes caused by early versions of the perp-swap product.)

Perp-swaps were also a key offering for now-bankrupt exchange FTX, which innovated by settling in dollars rather than bitcoin and listing pairs in a long tail of obscure altcoins. Of course, both FTX and BitMEX are centralized operations. As a DEX offering derivatives, dYdX was an early mover, rolling out its first perp-swap offering in 2020 using a centralized orderbook, matching engine and a noncustodial setup built with Ethereum smart contracts.

Three years later, the majority of DEX trading activity is still on spot-trading venues. The leading exception is dYdX.

The volume on dYdX today is largely thanks to two developments in 2021: 1) a shift off the Ethereum mainnet chain onto layer-2 rollups built by Starkware for faster and cheaper transactions; 2) the launch of the dYdX token, used for governance, security and, most critically, rewards. These changes became salient features of what is known as dYdX v3, enabling dYdX to increase trading volumes and quickly go from three listed pairs to more than 30.

Early-mover advantage has been a powerful factor: the last new listing dYdX announced was Tezos (XTZ-USD) in May 2022. Without adding market pairs or developing new features, dYdX retains a dominant position among derivatives DEXs.

Instead of adding listings or features, dYdX developers have focused on faithfully delivering the basic experience of trading on a centralized perp-swap exchange – especially for professional traders who trade via application programming interface (API). “For institutions, it’s important that it feel similar,” Juliano said. “We have made a lot of strides. Our current product that we built on top of Starkware was a huge step up.”

Why professional traders use dYdX v3

According to Juliano, about 80% of volume comes from these “institutions” interacting via API, while the remaining 20% comes from “prosumers” who trade via the exchange’s user interface.

I make a few assumptions about what Juliano means by “institutions.” It isn’t insurance and pension funds, or large asset managers. It’s small hedge funds and proprietary trading desks. They’re here for profit, not for learning or for innovation window-dressing. “Institutions” is a commonly used shorthand, but I prefer “professionals.”

On any given day there are a half-dozen trusted centralized derivatives exchanges with multiples greater volume than dYdX. Why do these professionals choose a smaller, quasi-decentralized venue?

Reason #1: Transparency

Eric Qiu is a trader at CMS Holdings and is known as a dYdX bull, based on research he published earlier this year under a pen name, predicting DEX growth and continued dYdX dominance of the DEX derivatives category. CMS is a user of dYdX, a venture investor in the project, and a buyer and a trader of the dYdX token – holding equity, locked tokens and liquid tokens.

The firm’s use of dYdX starts with three letters: “FTX.” The transparency and security of the Ethereum blockchain provides assurances against misuse of funds, like the alleged pooling of exchange deposits with investment funds that brought FTX to bankruptcy.

“It’s preventing that black-swan event,” Qiu said. “In DeFi it's very simple to see. I deposited $100 million in this exchange and there's $100 million sitting in this wallet. On a centralized exchange you don't know where the liabilities stand.”

There’s some evidence beyond anecdote: monthly notional volume on dYdX got a bump in the first few months of 2023 – but it can easily be explained by a concurrent market rally after December lows.

Reason #2: Regulatory arbitrage

To one extent or another, the most liquid cryptocurrency derivatives markets have always been off-limits to users in the most regulated jurisdictions. That remains true today: neither dYdX nor Binance Futures offer products in Canada or the U.S.

It seems regulators across the world are friendlier to DeFi than those in the U.S.: dYdX specifically excludes just the U.S., Canada and a list of countries subject to U.S. sanctions. Binance, meanwhile, limits its service to about 100 countries, with notable exclusions on every continent.

There are many places in the world where dYdX is accessible, while Binance is not. And the penalties on Binance include loss of funds via the exchange’s stated right to “terminate, suspend, close, hold or restrict your access to any or all of your Binance Account(s)” – something that dYdX’s Ethereum smart contracts protect against.

For market makers, which likely make up a significant percentage of dYdX’s professional volume, that makes the exchange doubly attractive.

“For a certain segment of traders, dYdX offers something that's hard to get elsewhere,” said Joshua Lim, former head of derivatives at Galaxy and Genesis Global Trading, now co-founder of Arbelos Markets, a principal trading business focused on crypto options. “If someone really wants levered exposure on ETH or BTC and can't get it on Binance, they will have to go somewhere else. Maybe that means they pay 25 or 50 basis points more, but there aren't many good alternatives. Customers are willing to pay a higher spread for access.”

Reason #3: Cheaper trades

Transparency and security might be enough for dYdX to charge a premium, but anecdotally, dYdX fees in some areas are lower than they would be on centralized derivatives exchanges.

Fees on dYdX compare favorably to centralized counterparts when depositing or withdrawing funds and when trading, "99% of the time" – especially if you count token rewards, Qiu said.

Of course, fees aren’t the only ways trade can cost money. In less-liquid markets, slippage costs traders money too, when the price moves temporarily on a trade that is larger than the market volume can absorb.

However, liquidity is a binary problem: either there is enough to execute a trade, or there isn’t. On dYdX, ETH and BTC markets handle hundreds of millions of dollars in daily notional volume, with a handful of altcoin markets in the 10s of millions. It’s enough for most traders, Qiu said. In thinner markets, limit orders can protect against excessive slippage.

Changes in dYdX v4

Earlier, I covered how dYdX v3 has been slow to add new features and market pairs. The core team of developers has been focused on building dYdX v4. The v4 release will move the exchange onto an appchain – an application-specific blockchain using Cosmos SDK. With this purpose-built blockchain for dYdX come three more salient developments: 1) decentralizing the dYdX orderbook and matching engine, 2) allowing permissionless addition of new market pairs and 3) distributing transaction-fee revenue to token holders.

Permissionless markets

In dYdX v3, a team of project developers has determined which market pairs to add to the exchange. The dYdX v4 update changes that, allowing the addition and removal of market pairs via on-chain governance.

Fast addition of new pairs has always been a differentiator for certain exchanges. Those more willing to take on regulatory risk have benefited from being first to provide access to new coins when they pop. Sometimes, these user-acquisition opportunities are ephemeral, as with memecoins that spike in volume before fading from relevance.

If permissionless market-pair additions work as intended, dYdX could go from being among the slowest exchanges to add new pairs to being among the fastest, providing opportunities to attract users from centralized competitors.

Fee distributions

Like many cryptocurrency exchanges, including both DEXs and centralized venues, dYdX uses both rewards and fees. Users pay fees per trade and receive rewards in the dYdX token, which in this function acts like a loyalty point.

See also: Centralized Exchanges Are Here to Stay | Opinion

Exchanges are some of the most profitable operations in crypto; over the long-term, no exchange should pay out more in rewards than its fee revenue. However, in DeFi, net payment for user acquisition is often the case. In 2022 Q4, it was so at dYdX. According to Messari: dYdX notched $128.1 million in revenue versus $197.3 million paid out in rewards, recording a yearly net loss of $69.3 million.

That’s changed recently, Juliano said, following a rewards cut that pushed dYdX on-chain exchange operations into the black. "Our revenue started being higher than the dollar value of the token emissions,” he said. “Now people are paying on average to use the product versus just being incentivized to use it.”

In the future, it will be up to on-chain governance to determine that ratio – and holders of the dYdX token will be the ones receiving fee revenues. “No central party (including dYdX Trading Inc.) will have the ability to receive trading fees on dYdX v4,” the core team promised when v4 was announced in January 2022.

“I think people don't realize how lucrative dYdX is and how rare that is in crypto,” said Qiu. “You can go to the top 500 coins and you can look at the coins that actually generate revenue. There might be five. To be profitable while growing is super impressive and super rare.”

Conclusion: Decentralization required

The features of dYdX v4 may be more than additive. They may be existential. The U.S. Commodity Futures Trading Commission (CFTC) on Sept. 7 announced settlements with three derivatives exchanges charged with failing to register for appropriate licenses and illegally offering leveraged financial products.

The market is paying attention: the dYdX token was down about 9.5% since that news, as of Monday, more than three times ether’s drawdown over the same period.

Centralized exchanges are under a higher degree of regulatory pressure, and a hybrid, quasi-decentralized approach may be attractive to them, as Axelar co-founder Sergey Gorbunov wrote in a CoinDesk op-ed, earlier this year.

See also: Galen Moore – 'Super App' May Be Web3's Super Power | Opinion

Whatever they do, they’re likely to face increased competition from decentralized exchanges: as interoperability infrastructure matures, DEXs can onboard from any chain and offer pairs in any token.

Those that aren’t willing to take a step toward more complete decentralization may find themselves doubly squeezed in the middle.

“Liquidity is bifurcating in two directions: one points toward highly regulated venues like CME,” Lim said. "At the opposite extreme is dYdX.”

“There's a ton of open regulatory questions around this type of permissionless protocol, but at least it's all on-chain,” Lim added. The trust factor there comes from knowing that the collateral is segregated and lives on-chain and that they're applying the same uniform rule set for margin management and liquidations for everyone. That's where many credit issues of the last cycle began: uneven and discretionary application of margining rules.”

The path to adoption in DeFi may turn out to be straightforward: market infrastructure that works as expected and maintains rules and transparency. CME's progenitor, the Chicago Mercantile Exchange, was founded in 1898. Innovation seems overdue.