DYDX Valuation Report: Unlocking Panic and the Truth of Data

Written by: Gryphsis Academy

1. Introduction

In the previous report "dYdX v4: Improvements in Economic Model and Valuation Outlook," we primarily studied the updates of the dYdX v4 version, discussing the version features, marginal improvements compared to v3, and the reasons for dYdX's choice to leave Ethereum for Cosmos. We concluded that the combination of Layer 1 staking, fee distribution, and the introduction of Cosmos-native stablecoins will collectively improve the fundamentals of the DYDX token, bringing continuous benefits to the token.

Since our last report, dYdX has made some exciting improvements and developments. Recently, the new version has been launched on the mainnet, receiving a positive market response and a strong increase in token price. However, it is also worth noting that in December, dYdX will face a large number of initially allocated tokens being unlocked (accounting for 15% of the total token supply). How will the market react to the potential selling pressure? Will the token release lead to inflation and dilute the benefits brought by v4? Can the positive effects of the new version continue to drive the growth of the DYDX token? Is December the last opportunity to get in? To explore the development prospects of dYdX and the expected value of the DYDX token in more depth, this article will be data-driven, building on the previous work and analyzing from a valuation perspective. We will use DCF and comparable analysis models to reasonably predict dYdX's revenue and token price, and discuss the potential impacts of this selling pressure on v4 staking yields.

2. Overview of dYdX

dYdX is a pioneer in decentralized perpetual contract exchanges, with its unique order book model providing a user experience comparable to centralized exchanges. Today, its market penetration has reached 60% of the total DEX volume. The new architecture and marginal innovations of v4 give dYdX stronger competitiveness. On October 24, dYdX announced the release of dYdX Chain V1.0 and open-sourced its code, marking the official start of the v4 upgrade and the transition from the Ethereum Layer 2 network to an independent blockchain within the Cosmos ecosystem.

Open-source code is at the core of the blockchain spirit, bringing transparency to developers, allowing them to review, detect errors, and improve quality. According to the initial developers behind the exchange, dYdX Trading Inc., the dYdX Chain V1.0 version and its order book have been fully developed and passed final audits. The v4 upgrade will make dYdX completely decentralized and community-operated, meaning the company will no longer control the dYdX protocol and will not charge trading fees.

On October 27, dYdX Chain officially launched on the mainnet. As an independent Cosmos Layer 1, dYdX Chain was officially launched on the mainnet by the dYdX Ops subDAO, with validators creating the genesis block of dYdX Chain at 01:00 (UTC+8) on October 27. The public front end for bridging by the dYdX Operations subDAO will go live on October 30, 2023, pending official confirmation and testing. After the genesis, it will be divided into Alpha and Beta phases, with the Alpha phase starting on October 30, 2023, focusing on enhancing network stability and security. The Beta phase will enable trading without rewards, and the transition from Alpha to Beta will be determined by governance votes and other factors.

This article will conduct a valuation analysis of dYdX based on the previous report, combined with the token unlocking situation and v4 version features.

3. Valuation Model

Our valuation is based on discounted cash flow analysis (DCF) and comparable analysis methods, both of which are detailed in our valuation model (DYDX Valuation Model) and can be adjusted according to future actual market conditions. Below are the detailed descriptions and explanations of the valuation methods.

DYDX Supply in Valuation

Although validators and stakers on dYdX Chain receive all protocol fees (i.e., only staked DYDX tokens can generate cash flow from the protocol), due to the freely circulating, unlocked DYDX tokens being freely delegated to nodes for staking rewards, we choose the total token circulation as the basis for valuation, rather than excluding the circulating supply after staking. Our valuation date is set for December 31, 2023, considering the circulation after the unlock in December, with an effective token base of 446M.

Top-Down Approach

This article adopts a top-down valuation approach, starting with the total derivative trading volume for each forecast year, multiplied by the DEX penetration rate to estimate the DEX derivative trading volume for that year. Then, by calculating dYdX's market share, we derive the trading volume for dYdX for that year, and finally estimate the protocol revenue based on the effective fee rate.

3.1 Discounted Cash Flow Analysis (DCF)

dYdX generates revenue by charging users fees, which in turn produces cash flow. Before v4, the protocol was managed by dYdX Trading Inc., and all cash flow belonged to the company. After the improvements in v4, dYdX is controlled by the dYdX Operations subDAO, implementing fully decentralized management. dYdX officially announced that dYdX Chain will distribute all protocol fees, including USDC-denominated trading fees and DYDX-denominated gas fees, to validators and stakers. We can assume that DYDX token holders can capture 100% of the cash flow from the protocol's development.

Based on the above conditions, we believe that the discounted cash flow method is the most suitable for valuing the DYDX token price. The discounted cash flow method (DCF) is an absolute valuation method used to estimate the value of an asset based on its expected future cash flows. The principle is that a company's value is calculated based on the future cash flows it can generate, discounted at a rate that reflects its risk. Our model uses data up to September 30, 2023, as the basis, with a 5-year forecast period, and represents the long-term cash flows of the protocol under continued operation with a terminal value, estimating the value of the DYDX token as of December 31, 2023.

3.1.1 Assumptions

Trading Fees: Compared to various perpetual contract protocols, dYdX has a relatively low fee level, providing a certain advantage. v4 divides fees into 9 tiers based on v3, offering different trading rewards. By dividing the fee income for 2022 by the trading volume, we calculate an average fee rate of 0.025% as the protocol's fee rate. As market competition intensifies, the overall fee rate for exchanges decreases, ultimately leading dYdX's effective fee rate to linearly decline to 0.015% (shared by both buyers and sellers), approaching the preferential fee rate level of Binance VIP 9, with a monthly trading volume of $2.5 billion.

Discount Rate: Based on the assessment of the current protocol development and market risks, we set the cash flow discount rate for 2023 to 2028 at 29%. In calculating the discount rate, we use the 10-year U.S. Treasury bond as the risk-free rate and BTC as the market benchmark. The β value is derived from a regression model of DYDX returns as a function of BTC returns. The regression analysis is based on one year of data, selecting a starting time that aligns with the current market price, specifically from August 1, 2022, to September 30, 2023. The Capital Asset Pricing Model (CAPM) calculates the cost of capital at 29.10%. The regression analysis shows a significant positive correlation between DYDX price and BTC returns. Therefore, we choose 29% as the discount rate, which is similar to the average return rate of venture capital funds at 30%, making it quite reasonable.

Terminal Price-Earnings Ratio: DeFi is a light-asset industry, so we choose the exit multiple method to backtrack the terminal value. Referring to the price-earnings ratios of publicly listed traditional exchanges, we ultimately select 10 times as the final exit multiple for DYDX.

Expected Trading Volume: Trading volume is directly related to the protocol's revenue and is a core driver of DEX value. To predict the potential value range of DYDX under different market conditions, this report assumes three different trading volume growth scenarios.

Each forecast period starts with the annualized total derivative trading volume since September 30, 2023, applying annual growth rates based on this. According to industry development patterns, we assume that during the forecast period (2023 to 2028), the derivative trading volume will grow rapidly in 2024-2025, then gradually slow down each year, eventually reaching negative growth. This is due to the expectation of BTC halving next year and the Federal Reserve's interest rate cuts, suggesting that the crypto world may experience a bull market in the next two years, hence we give higher growth expectations for 2024 and 2025.

To obtain dYdX's trading volume, we set based on historical data that the protocol has a constant market share of 40%-60% of the total derivative DEX trading volume (varying under different market conditions). Below is the expected trading volume profile for DYDX under each scenario:

Base Case: Derivative trading volume grows at 80% in 2024, gradually decreasing to -5% in 2028. With the booming development of DeFi or the rising adoption rate of DEX, the total trading volume for dYdX in 2028 is expected to be $2.93 trillion.

Bear Market Case: Derivative trading volume grows at 50% in 2024, gradually decreasing to -5% in 2028. With regulatory sanctions slowing growth in cryptocurrencies or a decline in overall DEX usage, users are more inclined towards CEX, leading to an expected total trading volume for dYdX of $0.91 trillion in 2028.

Bull Market Case: Derivative trading volume grows at 100% in 2024, gradually decreasing to -10% in 2028. With the successful implementation of the dYdX chain and v4 version, and significant favorable developments for the cryptocurrency industry under regulation, the expected total trading volume for dYdX in 2028 is $6.75 trillion.

In the past 9 months, the total trading volume of the top 20 derivative DEXs has reached approximately $0.49 trillion, with dYdX's share accounting for $0.26 trillion. The total trading volume of the top 10 centralized exchanges for derivatives is $20.49 trillion. At the time of writing, DEXs account for about 2%-3% of the total trading volume of CEXs.

Multiplying the expected trading volume by the fee rate, we derive the following expected revenue:

3.1.2 DCF Analysis

It should be noted that the present value of the tokens in this article is based on the token circulation as of December 31 and does not involve the incremental token unlocks in subsequent years. However, considering the relatively aggressive discount rate of 29%, the dilution risk for dYDX under current conditions can be offset to some extent.

Below are the DCF results under the three scenarios:

Base Case: In this scenario, the DYDX token price is expected to be $4.86, with a protocol valuation of $2.17 billion as of December 31, 2023.

Bear Market Case: In a bear market, the DYDX token price is expected to be $1.62, with a protocol valuation of $724 million as of December 31, 2023.

Bull Market Case: In a bull market, the DYDX token price is expected to be $10.56, with a protocol valuation of $4.72 billion as of December 31, 2023.

3.1.3 Probability-Weighted Scenario Analysis

We assign a 25% probability to both the bull and bear markets, and a 50% probability to the base case. The calculated probability-weighted DCF valuation for DYDX price is $5.48, with a protocol valuation of $2.44 billion. As of September 30, 2023, the DYDX price was $1.96, indicating a potential upside of 179.34%.

3.2 Comparable Analysis

Comparable analysis is a method used to assess the value of a company or project relative to its peers. The basic assumption is that blockchain projects of similar scale and nature should theoretically have similar valuation multiples. The comparable analysis method typically uses price-to-sales (P/S) and price-to-earnings (P/E) ratios to compare the valuation of the subject being assessed.

When conducting comparable analysis, it is crucial to select reference objects that are as similar as possible to the analyzed company or project in terms of industry, business model, risk profile, and market dynamics. By ensuring comparability in these aspects, we can reduce the impact of external factors on the analysis, allowing us to focus more on the intrinsic value factors of the analyzed enterprise or project. The four comparable projects we selected all belong to the decentralized derivatives contract trading industry: Synthetix, GMX, Gains Network, and Perpetual Protocol. They share similar business characteristics and risk profiles, and all four projects are listed and traded on leading blockchain exchanges like Binance, meeting the market standards for exchanges, which will help enhance the effectiveness of the comparative analysis.

Finally, by using DEX derivative projects within the same decentralized finance market as comparables, we can address the differences in market risk analysis across different industries.

2023 Cumulative Revenue for 5 Protocols, Source: Token Terminal

The above is a comparative chart of the annual cumulative revenue of these five projects as of October 27, 2023. From the chart, it can be seen that GMX has the highest project revenue, being the only one among the five that has exceeded $100 million, while dYdX's revenue is second at $65.4 million, and Perpetual Protocol has the lowest revenue at $63 million.

Below is a summary analysis of the comparable projects:

dYdX: Since its launch in 2021, the DYDX token has faced challenges of supply scarcity and lack of utility. Despite holding over 50% market share in the DEX perpetual contract market, its token circulation ratio is far below that of peer projects. Before the v4 version, the main uses of the DYDX token were governance and staking for fee discounts, but the new version plans to introduce more uses, such as distributing all fees generated by the dYdX Chain to validators and token stakers in the future. Of course, investors may still be concerned about the impact of future large-scale token unlocks.

GMX: GMX is a DEX platform supporting spot and perpetual contract trading, focusing on derivatives trading. Unlike other comparable projects, GMX adopts a global liquidity model, where users provide liquidity by purchasing and staking the liquidity tokens GLP issued by the GMX protocol. Holders of $GMX can stake their tokens and earn 30% of the protocol fees generated by GMX. Stakers of $GMX can also receive $esGMX and multiplier points (MP) to further enhance their earnings. Holding $GMX also grants voting rights in the governance of the GMX protocol, allowing them to have a say in the community fund.

SNX (Synthetix): Synthetix's perpetual contract products are not aimed at end-users but are provided in the form of backend products to support developers and DeFi derivatives liquidity platforms. Users can interact with DeFi products that have integrated Synthetix Perps contract features without having to directly use or interact with Synthetix Perps contracts.

Currently, the trading volume of Synthetix perpetual contracts is mainly generated by the spot and derivatives trading platform Kwenta, which is essentially a decentralized contract product aimed at trading users, built on Synthetix Perps components. The circulating supply of SNX tokens is almost equal to the total supply. SNX still adopts a weekly inflation system as a reward for SNX stakers. Stakers have different SNX reward pools on Optimism and Ethereum, with varying annual staking returns. Currently, SNX has the lowest inflation, which varies based on the staking ratio. However, SNX inflation rewards are subject to a one-year lock-up period, further reducing the impact on token supply. Nevertheless, the utility of SNX tokens may change in the future.

Gains Network: Gains Network revolves around the ecosystem's ERC20 utility token ($GNS). The design of $GNS is intended to serve as the utility token for the platform, achieving ownership of the protocol through revenue generation and platform governance (coming soon). It includes platform fees earned by $GNS holders through single-sided staking, as well as burning $GNS using platform revenue. The leverage cap within the Gains Network platform is 9 times, with a lower cap on opening interest, which may not be the ultimate choice for all traders, but it has already established a solid position among beginner traders. Currently, Gains Network allocates 61.23% of its revenue to $GNS stakers.

Perpetual Protocol: Perpetual Protocol is a decentralized perpetual contract trading protocol built on Ethereum. The protocol uses a virtual AMM (vAMM) design, which can support leverage of up to 20 times, allows short positions, and has lower slippage compared to other AMMs. Unlike automated market makers used for token swaps and price discovery, vAMM is solely used for price discovery to handle leverage and short positions. Similar to Uniswap, traders can trade with vAMM without a centralized managing entity, and its design is market-neutral and fully collateralized.

PERP is the ERC-20 native token of the protocol, allowing community members to participate in protocol governance and stake their tokens in the staking pool for a specific period. In return, holders receive staking incentives, including PERP rewards and trading fees.

3.2.1 Variable Considerations

Price/Earnings Ratio (P/E): The price/earnings ratio is a financial metric that can be used to measure the relationship between the current token price of a blockchain project and its earnings per share. This ratio is typically used to assess the investment value and risk level of a project. P/E ratios can vary significantly across different industries and project types, so they usually need to be compared with peer blockchain projects or market averages.

Price/Sales Ratio (P/S): The price/sales ratio is commonly used to assess the valuation of traditional companies based on revenue. For DEX projects, protocol fees (referred to as "sales revenue" in traditional companies) are key factors in evaluating their financial performance and sustainability. By using the price/sales ratio, the relationship between market capitalization (price) and the fees generated by the protocol can be understood, revealing how the market assesses the revenue-generating capability of the protocol.

Average P/S Ratio: We adopt the market multiple method commonly used in the crypto industry, using the average P/S ratio of the five comparable projects as the market multiple. By calculating the average, we essentially consider the upper and lower limits of the comparable projects, providing a balanced estimate of the market multiple. Therefore, we choose to use the average of the comparable projects as a quantitative market multiple to avoid potential biases that may arise from relying solely on maximum or minimum values.

Median: Statistically, the median is not affected by extreme values in the distribution sequence, which enhances its representativeness of the distribution. Therefore, we choose the median as a reference factor for the market multiple.

Annualized Total Revenue: Analyzing the revenue generated by blockchain projects can assess their ability to generate income and maintain operations. Revenue is a key indicator of a project's financial health and growth potential. The assessment of protocol fee revenue helps understand the income streams directly related to DEX trading activities and the profitability of DEX protocols. Protocol revenue can come from various sources within the DEX protocol, including trading fees, margin fees, liquidation fees, and funding fees. By considering protocol fee revenue as a variable, analysts can evaluate the diversification of income streams. This helps assess the protocol's ability to withstand market fluctuations and its long-term viability.

Annualized Revenue to DYDX Holders: In traditional stock markets, the "earnings" in P/E refers to the net profit actually earned by a company over a specific period (usually quarterly or annually), which is an important financial metric for investors to gauge a company's profitability and financial health. However, in the blockchain space, the concept of "earnings" may not apply in the same way. This is because DeFi projects do not profit in traditional ways; they typically do not have net profits or earnings per share like traditional companies. Instead, their economic models may involve token trading fees, liquidity mining rewards, lending interest, and other net income converted to the project or token holders.

3.2.2 Comparable Analysis Valuation

The above chart shows the project valuations and token prices based on the price/earnings ratio (P/E) and price/sales ratio (P/S). We estimated the annual fee revenue and net income of the projects using data from January to September 2023. The estimated annual total revenue for dYdX is $85.81 million, indicating that dYdX has good revenue-generating capability. Additionally, dYdX's P/E ratio is relatively low compared to the average ratios of the selected decentralized derivatives protocols, suggesting that it may be undervalued. Finally, based on the P/E ratio, the potential price of dYdX is derived to be between $1.26 and $2.34.

3.3 Comprehensive Analysis

Finally, we conducted sensitivity analysis on the key variables of the DCF and obtained the final valuation range.

At the same time, we selected the maximum and minimum values of the probability-weighted DCF valuation under different terminal price-earnings ratios and discount rates from the sensitivity analysis. Due to the differences in value capture and tokenomics among the five comparable projects, we assign more weight to the P/E valuation (40%) in the comprehensive valuation analysis to enhance the model's accuracy, while the P/S valuation also has certain reference value, thus receiving a weight of 10%. Based on this, the total weight of the comparable analysis is 50%. The remaining 50% is assigned to the weighted DCF valuation. Ultimately, the comprehensive analysis yields a DYDX token price range of $2.99 to $4.12, with a fully diluted valuation (FDV) range of $2.993 billion to $4.118 billion.

Since the DCF provides a higher valuation, it overall raises the comprehensive valuation. The impact of v4 on the economic model is highlighted by the fact that trading fees have shifted from being collected by dYdX Inc. in v3 to being collected 100% by staking nodes, indicating a significant growth potential for cash flow captured by the token, which should be reflected in a higher valuation multiple. Therefore, using the average P/E and P/S valuations of comparable protocols may lead to some underestimation.

It is worth noting that the establishment of the valuation model and the derived token prices are based on the current data and market operating conditions provided. Future actual market dynamics and the operational performance of the dYdX project will ultimately determine its true market value.

4. Discussion on Unlocking

4.1 Valuation Premium

In the valuation analysis of dYdX, there is a noticeable valuation premium, primarily due to the limited liquidity supply caused by staking. As the L1 token of the dYdX chain, DYDX is used for both fee payments and validator staking to ensure on-chain security. Currently, the average staking rate across the entire proof-of-stake (PoS) network is 52.4%. Referring to existing PoS public chains like BSC and Solana, which have long-term staking rates between 40% and 70%, the staking rate of the dYdX chain is likely to exceed 40%. This will significantly reduce the circulation of DYDX, and with unchanged token demand, the price will rise significantly.

4.2 Staking Yield Estimation

In December of this year, dYdX will unlock nearly 150M tokens (accounting for 15% of the total supply), increasing the token circulation from the original 296M to 446M. With such a large-scale one-time unlock, the market may have concerns about whether these tokens will lead to significant short-term inflation, diluting the benefits brought by v4.

In this regard, we believe that the market need not worry about the token unlock in December. The reason is that the large-scale token unlock will not lead to a significant increase in token circulation. We can note that the tokens being unlocked are the initial allocations distributed to the team and investors, and they are likely to stake the vast majority of these tokens. Generally, in the early stages of PoS public chain development, users tend to have lower staking rates due to risk considerations, resulting in relatively high annualized returns. As the public chain develops, the staking rate will gradually increase. Currently, the average staking level in the market's proof-of-stake (PoS) networks is about 52.8%, with an on-chain yield of 10.2%. Based on this, we estimate the staking situation and APR for the dYdX chain (as shown in the figure).

According to our valuation model, dYdX's revenue for 2023 is $85M. Assuming that the team and investors stake 80% and 50% of the unlocked tokens, respectively, we can derive an annualized staking yield of 20.27%, with a staking rate of 41.2% (calculated based on circulation). The staking rate on the dYdX chain will gradually increase each year and eventually stabilize (around 46.68%). If the price aligns with the base case valuation, the annualized yield will rise to 44.5% after 5 years, indicating significant growth potential for the token. Therefore, we believe that the team and investors are likely to stake the tokens, and the dilution risk brought by the token unlock at the end of the year is relatively small.

5. Conclusion

This article adopts a top-down valuation approach, using cash flow analysis (DCF) to reasonably estimate the protocol value and token price of dYdX. Through probability weighting, the protocol valuation is $2.445 billion, and the expected price of $DYDX is $5.48, indicating a potential upside of 2-3 times. Finally, combining P/E and P/S valuation methods, the comprehensive analysis yields a DYDX token price range of $2.99 to $4.12 at the end of 2023, suggesting that there is still some upside potential compared to the current market price of DYDX.

In light of the potential dilution risk brought by the token unlock in December, we believe that since the primary allocation of the unlocked tokens is to the team and investors, and the staking incentives on the dYdX chain are strong, with an annualized yield exceeding 20%, the unlocked tokens are likely to be staked and will not exert significant selling pressure on the market.

References

1. https://docs.dydx.community/dydx-governance/
2. https://dydx.exchange/blog/v4-rewards-and-parameters
3. https://dydx.forum/t/dydx-v3-vs-v4-new-trader-rewards-overview/881
4. https://www.washingtoncompanysearch.com/companies/dydx-trading-inc/
5. https://help.dydx.exchange/en/articles/4798063-location-restrictions
6. https://www.binance.com/en-JP/feed/post/818240
7. https://dune.com/dydxanalytics/dydx-unified-dashboard
8. https://dune.com/impossiblefinance/derivatives-perpetual-markets
9. https://members.delphidigital.io/reports/dydx-valuation-analysis-dex-perps-comparison#synthetix-f08e

Disclaimer: This report is an original work completed by @elliett2077 and @0xCryptoAndrew, students of @GryphsisAcademy, under the guidance of @CryptoScott_ETH. The authors are solely responsible for all content, which does not necessarily reflect the views of Gryphsis Academy or the organization that commissioned the report. The editing of content and decisions are not influenced by readers.

Please be aware that the authors may hold cryptocurrencies mentioned in this report. This document is for informational purposes only and should not be used as the basis for investment decisions. It is strongly recommended that you conduct your own research and consult with neutral financial, tax, or legal advisors before making investment decisions. Remember that past performance of any asset does not guarantee future returns.