IntoTheBlock Report: How DEXs Use Incentives and Tokenomics to Generate Revenue

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On-Chain Markets Update by Juan Pellicer, IntoTheBlock

Web3 is all about value transactions, and exchanges are in the best position to provide that utility and capture value. But where does that value go?

The most basic need that DeFi users demand is an exchange of tokens. Charging a small fee for this exchange is one of the most direct ways to generate cash flow for a DeFi protocol. These protocols are decentralized exchanges, and nowadays some of them are generating hundreds of millions of dollars in daily trading volume and generating daily revenues that exceed $1M in certain cases. These are the three exchanges that produce the most revenue: 

DEX24h Trading Volume24h Revenue (Fees)
Uniswap$1.3bn$2.04m
Pancakeswap$474.2m$1.19m
Sushiswap$288.3m$864.76k
As of January 31, 2021. Source: Tokenterminal, IntotheBlock.

Revenues come from the fees that traders pay for the exchange of tokens. So the fees accrued are proportional to the value traded on each decentralized exchange. These fees tend to vary from 0.30% to 0.01% depending on each protocol and pool in particular. 

Beyond comparing these figures, it is interesting to explore how these revenues flow differently on each protocol, since these can be distributed very differently among all the parties involved with the protocol: the liquidity providers, the DAO/team supporting the protocol, or holders of the protocol’s token. Incentivizing these parties correctly is critical in a successful decentralized exchange. And that process can turn a wavering exchange into a steady revenue machine.

Daily volume and fees of Sushiswap on Ethereum, via IntotheBlock indicator.

The first model to review are those decentralized exchanges that do not extract value at all from its trades outside of the swap operation. The act of transacting tokens is merely an exchange between liquidity providers and traders, which pay an incentivizing small fee towards those providers. In this scenario, neither holders of the protocol’s token nor the team behind the protocol are economically rewarded. 

The best example is Uniswap: With no protocol fees, all the trading fees accrue towards the liquidity providers. The protocol’s token does not accrue part of the revenue and governance is its main utility, which is not necessarily “valueless” since governance token holders have the power to mandate how the protocol works. For example, they could potentially approve the introduction of  a protocol fee that would produce revenue. 

The current lack of incentivized pools with Uniswap’s UNI token mitigates the potential selling pressure that those might bring. Their token is not easily rewarded. For this reason the protocol does not actively incentivizes to provide liquidity to its pool with its main token:

Diagram of a protocol where value flows only between liquidity providers and traders.

Most of the decentralized exchanges fall in a second category that takes a different approach. Not all the trading fees accrue towards liquidity providers, with part directed toward stakers of the protocols tokens. 

This consequently introduces buying pressure because it is an appealing reason to buy and hold (and usually stake) these protocol’s tokens. Since this decision has an impact over liquidity providers profitability, many liquidity pools are incentivized with liquidity mining rewards with the main protocol tokens. 

This tradeoff attracts liquidity, which improves the exchange performance with better exchange rates and thus more fees are accumulated, but introduces some selling pressure of the protocol’s token to the system. This approach is one of the most successful mechanisms to attract liquidity to a protocol, as can be seen in the next example with the historical liquidity of Curve Finance: 

Liquidity provided on Curve Finance, via IntotheBlock indicator.

This model opens the possibility of including take rates, where part of the fees are accrued directly by the team/DAO behind the protocol. This is a coherent aspect considering that these protocols require active and constant management to improve the product or tweak certain parameters. Activities such as client support or social media presence require constant attention  and play a huge role in the success of these products. As such they should somehow be rewarded.

Diagram of a protocol where value flows between liquidity providers, token holders, traders, and DAO/team.

There is no distribution structure set in stone about how to divide the percentage that each group should receive. In fact, each protocol practically sets a different amount than their competitors. In some cases, they do not even direct fees to some of these groups at all. The protocols shown are the ones generating the most revenue. All of them have achieved impressive revenue figures despite their different schemes. 

DEX% fees to LPs% fees to token holders% fees to team / DAO
Uniswap100%
SushiSwap, Traderjoe83.3%16.6%
SpookySwap85%15%
Curve50%50%
PancakeSwap68%20%12%
Balancer90%10%
dYdX100%*
As of January 31, 2021. * Fees are reduced for token holders.

Tokenomics can be used to incentivize the team behind the protocol. If the DAO/team allocates a considerable percentage of the initial token distribution, redirecting a constant amount of the fees towards them could doubly incentivize the team while taking some incentives from liquidity providers or token holders.

Certainly there is room for experimentation to try to better align incentives between all the parties involved in a protocol and newer methods not considered in the previous table exist. For example the Osmosis exchange penalizes those liquidity providers that remove liquidity with a small fee (known as exit fee). Since removing liquidity is an action that harms both the protocol and the traders that make use of them, they consider it fair to extract some value to incentivize liquidity providers to stay for the long term and partly mitigate what is known as ‘mercenary’ liquidity. That is a concept that depicts how liquidity rapidly changes from one pool to another by trying to chase those pools with the best incentives.

Aligning the parties involved in a protocol is not a trivial task. Over the long term, we will see what works best and what will fail. Ideally, liquidity providers are rewarded fairly to maintain their liquidity, traders’ exchanges are reasonably uncostly, token holders are accruing considerable revenue and the team maintaining the protocol is rewarded accordingly. Will the protocols that we use today be around in five, 10 or 50 years? Legitimately and competitively balancing all these parties presented in the article could be the key to the success and sustainability of a decentralized exchange over a long period of time.

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