Thursday, 18 March, 2021
The Digital Investor
DEXes – from market making to valuations
This Digital Investor builds on concepts explained in The Bridge and analyses the landscape of decentralised exchanges (DEXes) for investors, from market making to different players. The first section examines market-making in Automated Market Makers (AMM) and how liquidity providers (LPs) can use these properties to their advantage. The second section describes different players and their value accrual mechanisms in the space. And the final section analyses valuations in the DEX space.
2020 has been a remarkable year for Decentralised Finance (DeFi) applications. The liquidity mining kicked off by Compound quickly morphed into a stack of DeFi applications working homogenously. Lending/borrowing, exchanges, derivatives, asset management, and payment infrastructure are the broad categories of current DeFi applications. Decentralised exchanges play a pivotal role in facilitating everything else. In this article, we analyse market-making in DEXes and their valuations.
The alchemy of AMMs
Automated Market Makers (AMMs) are revolutionary. They democratised market making as anybody can be a market maker through AMMs. All one needs to do is provide liquidity to earn fees from trading. AMM apparatus has three critical players - liquidity providers (LPs) who provide liquidity, traders who swap assets, often creating arbitrage opportunity for the third player – the arbitrageurs. In this section, we shed light on the benefits of being an LP, ways to mitigate impermanent loss (IL), and desirable market conditions for the three players.
Figure 1 - Market conditions desirable for different AMM participants
Source - SEBA Bank
Though it is impossible to eliminate IL in the current setting, LPs can hedge IL in two ways - synthetically hedge the IL using various options strategies and choose pools based on protocol incentives that mitigate IL. However, the second alternative may not exist in perpetuity as protocol incentives will end at some time.
DEXes and their value accrual
We touch upon different DEXes, their USPs, and their value accrual mechanism in this section.
Uniswap championed the x*y = k model, also known as the constant product model. It allows a user to swap any two Ethereum based tokens. These swaps are facilitated by LPs who provide liquidity to pools. LPs currently earn 0.3% of every trade.
Liquidity providers earn (LPs) 0.3% trading fee right now.
Sushiswap, initially just a vampire attack on Uniswap, later started differentiating itself on standout features. A couple of Sushiswap products that stand out are Miso and Bentobox. Miso is a whole suite of contracts that allows project teams to launch their token. Different projects need tokens for different needs, and the launch methods will vary accordingly. Miso tries to cover these different methods. Bentobox is a lending solution that allows users to lend tokens in pairs (one to lend and the other as collateral). It also acts as a placeholder for tokens reducing the need to approve all the tokens, saving on gas fees.
LPs earn 0.25% of the trading fee.
0x is different from other DEXes. Instead of using liquidity pools to match orders, 0x takes the order book off-chain. It works on request for a quote model. Once an order is generated, relayers find the counterparty to execute the trade. After finding the counterparty, the order is executed on-chain.
ZRX is the governance token of 0x, and for a long time, there was no precise value accrual mechanism for ZRX. In January 2020, 0x v3 went live with staking. Users can now stake ZRX in pools set up by different market makers (relayers). Relayers facilitate trades, and each trade has a fee associated with it. Staking pools accumulate the fee over a seven-day epoch. The fees are then distributed to individual stakers based on their stake proportional to the pool.
Curve improvised upon the constant product market function to offer a constant sum market function for pricing trades. It facilitates swaps of stablecoins (USDC, USDT, DAI, sUSD, etc.) and highly correlated assets (WBTC and sBTC, sETH and ETH, and so on). The constant sum function allows Curve to support large trades with limited slippage.
CRV is the governance token of Curve. All the Curve pools charge a 0.04% fee currently. 50% of the fee goes to LPs, and the rest goes to veCRV holders who are DAO (Decentralised Autonomous Organisation) members. veCRV stands for vote-escrowed CRV; it is CRV locked for a time period.
1inch is an exchange aggregator that can split a single trade and bring liquidity from different exchanges. It gets liquidity and the best price from various exchanges, thereby making trades more straightforward. As 1inch sources liquidity from multiple DEXes, users don't have to spend gas numerous times to approve the same token. 1inch also has a gas token called Chi which allows users to tokenise gas and manage the gas price volatility better.
1INCH is the governance token of 1inch DEX aggregator.
Balancer is a generalised implementation of Uniswap, which allows LPs to create pools with more than two assets, i.e. Balancer is a multi-token automated market-making protocol. It generalises Uniswap's x*y = k model for multiple tokens, and a pool could have up to eight tokens in Balancer's first version. Liquidity providers can use these pools as portfolio rebalancing tool whereby they also earn a fee on trading instead of paying a fee for rebalancing.
LPs earn a fee set for the pool (by whoever deploys the pool). BAL is the governance token of Balancer. It is used to incentivise LPs via liquidity mining. The protocol does not charge anything to the traders; therefore, there is no direct value accrual mechanism for BAL.
Bancor launched the first-ever AMM in 2017. In the 2.1 version, Bancor allows LPs to provide liquidity in one token and Bancor mints equivalent amount of BNT for the same pool, and when LPs take the token out, Bancor burns equivalent BNT. However, LPs can add liquidity with BNT also. Bancor uses BNT to cover for impermanent loss of LPs. The IL protection works in the following manner –
Despite raising approximately USD 150 m in ICO, Bancor took time to figure out the product-market fit. BNT token added a lot of friction at the beginning and was deemed unnecessary by the Ethereum community. However, the team seems to be addressing these concerns in the latest v2.1
LPs earn a default 0.2% on Bancor pools along with incentives or liquidity mining rewards. The LPs can also set the fee. 30% of the liquidity mining incentives are for the non-BNT side of the liquidity, and 70% are for the BNT side of liquidity.
Kyber Network has a hybrid market-making approach – constant product function (x*y=k style) plus traditional market-making approach for on-chain liquidity focusing on the latter. Kyber Network used to be among the highest trading volume venues throughout 2019. However, as they were focused more on bringing traditional market-making on-chain, they missed out on capturing mind share through the DeFi summer. Kyber currently does less than 10% of Uniswap's daily volume.
KNC is the governance token of Kyber Network. Users can stake it in the DAO to participate in governance. The upcoming upgrade will also decide how much fees are charged to different liquidity protocols. These fees are distributed to KyberDAO and, thereby, users who have staked KNC in the DAO.
Table 1 – Summary of DEXes
Source: SEBA bank
In this section, we perform the discounted cash flow-based valuation for Uniswap and Sushiswap and then perform the relative valuation of DEXes. Coinbase's IPO has given a reference point for valuations of the entire exchange space, and we will use this to understand how other exchanges stack up.
Figure 2 - DCF for UNI
Source: SEBA Bank
Figure 3 - DCF for SUSHI
We now compare valuations among the DEXes. In figure 4, we look at the time series of P/E of different DEXes. P/S and P/E are the same as treasury takes care of the expenses and fee go directly to LPs or token holders.
Figure 4 – P/E of DEXes
Source: Token Terminal, SEBA Bank, Coingecko
Coinbase may command a valuation of approximately USD 100 bn on the listing and is trading at an implied valuation of $117 bn on FTX. It brought in revenue of USD 1.3 bn in 2020 and net income of USD 322 m. Assuming a 100% revenue growth and 30% net income margin, Coinbase commands a forward (FY21) P/S of about 45.79 and P/E of 152.64. Except for 0x, almost every DEX is undervalued compared to Coinbase. As shown in figure 5, Sushiswap is the most attractive exchange among the selected universe, and 0x is the most expensive.
Figure 5 – Comparison of DEXes with Coinbase
Source: Coinbase S1 filing, Token Terminal, SEBA Bank, Coingecko
Exchanges have been a thriving business in the digital assets landscape. Centralised exchanges such as Coinbase, Binance, and FTX have flourished over the few years. 2020 witnessed the Cambrian explosion of DeFi powered by DEXes. Given that DeFi users accrue actual cash flows, we think that DeFi and DEXes will find higher representation in the digital assets market. We expect DEXes to grow at a high rate during the next couple of years.
Assumptions for valuation –
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