Crypto exchange platforms enable the exchange of one digital asset for another. Centralized crypto exchanges have been offering cryptocurrency trading services since 2010, but with numerous hacks, trust issues, and scams, decentralized exchanges (DEXs) have become an alternative for many people. This guide explores how to evaluate a DEX using on-chain analysis. But first, let’s examine the rise of DeFi & DEXs.
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The rise of DeFi and DEXs
Ethereum is designed as the leading smart contract platform, which uses blockchain technology to enable the creation of smart contracts. This allows developers to build new protocols using these smart contracts on the Ethereum network, which can communicate with users in a decentralized manner. Among the growing category of protocols on the Ethereum network are decentralized exchanges (DEXs). These DEXs provide a decentralized trading platform, with all interactions taking place directly between the user (through web3 wallets) and the financial service provider, the DEX. Transactions on these platforms do not require intermediaries (as is the case with centralized exchanges), giving users full control over their assets during the transaction.
DeFi (decentralized finance) is the category of decentralized solutions that a DEX falls into. DeFi has seen tremendous growth since the famous “DeFi Summer,”; the name given to the summer of 2020 after the emergence of several new platforms in space. The DeFi ecosystem has expanded and developed significantly over the past year, driven in part by the rise of DEXs. DeFi offers advantages in terms of privacy and security, but it has also become popular among crypto users due to the availability of return-generating strategies.
DEX on-chain analytics: identifying the top pools
The DeFi ecosystem is composed of various types of DApps with unique features and services that differentiate them from each other. Some of the most common types of DApps include decentralized exchanges, lending protocols, and derivative protocols.
The primary role of DEXs as exchange providers is to maintain sufficient liquidity to facilitate the trading of token pairs. DEXs achieve this by allowing users to deposit pairs of tokens into pools provided by each protocol. These depositors earn exchange fees that are charged to traders using the DEX services.
On-chain data can identify the token pairs / pools with the highest trading activity across supported DEXs. It provides insights into pools of high liquidity and volume within the DeFi ecosystem.
The indicator above displays the top 10 pools ranked based on the volume of trade. The volume column aggregates the trading volume over a 24-hour period. Liquidity refers to the combined supply of both tokens in the trading pair. Fees, which are typically 0.3% in the case of Uniswap, are calculated based on trading volume and earned by liquidity providers. The indicator shows the fees collected in the last 24 hours. Finally, the return on liquidity (ROL) is an estimate of the expected return, excluding token rewards, that liquidity providers will receive from the pair, based on 24-hour data.
The return on liquidity (ROL) varies based on the trading volume and the amount of liquidity provided. It functions as a relationship between the two: higher trading volume leads to more fees generated, which leads to higher rewards for liquidity providers.
Conversely, less liquidity in a pool means a larger stake for individual liquidity providers, especially if the pool experiences high trading volume, resulting in greater rewards.
Volume and fees ratio
An essential metric to monitor is the volume of transactions processed by DEXs. This metric provides insight into the number of users on the platform and the fee income generated by liquidity providers through these transactions.
Since DEXs operate in a decentralized manner, they rely on liquidity providers (LPs). Users can become an MP by depositing funds into one of the DEX’s permissionless pools. LPs on a DEX earn exchange fees that are charged to users who trade on the platform. In other words, the revenue generated by the DEX through exchange fees is divided among the LPs.
In this case, the indicator below depicts the daily volume traded and fees generated on Curve’s pools on Ethereum.
The fees that the protocol generates stand as a derivative of the volume processed. The graph above shows the volume processed and the fees earned by MPs since September 10, 2022. The large increase in volume during the beginning of November is directly related to the collapse of the FTX exchange. Times of market volatility bring high trading volumes due to speculation.
Total Value Closed (TVL) and it’s meaning
Total value closed (TVL) is an important metric to evaluate. This gives us an insight into the value deposited in the protocol for the purpose of earning returns. In this case, as with the “Volume & Fees” indicator, the chart shows data from the Curve protocol on the Ethereum network.
Deeper liquidity pools improve stability and promote adoption of the protocol. The primary goal for decentralized exchanges (DEXs) is to increase their trading volume and the TVL to the protocol. Future advancements of the protocol must focus solely on this end goal. Reducing barriers for users participating in both functions of the protocol is a crucial aspect to consider.
As explained, the Volume & Fees indicator shows a sharp drop in the liquidity provided to the protocol during the months of November, correlated with the FTX collapse. During times of uncertainty, MPs have in the past rushed to protect their assets by exiting their positions.
DEX on-chain analytics and impermanent loss: explanation of its simulation
Offering liquidity in DeFi can be incredibly beneficial. However, it is crucial to consider other potential risks, such as permanent loss. This occurs when a pool needs to adjust its assets to maintain equal value between the paired tokens. This results in the loss of tokens for the LP if the value of one of the tokens changes relative to the other. This is a common problem faced by pools that require a 50-50 balance between the pairs.
On-chain ROI calculators, such as the one shown below, provide an easy method to estimate volatile loss / ROI based on the on-chain situation. These calculators help to track the permanent loss based on your liquidity provided.
The indicator you see above calculates and compares the return on investment (ROI) based on your input amount. This simulates the scenario of LPing the tokens instead of keeping them exposed (hodl). It provides the different outcomes of these two options as its output. In this case, we track the Uniswap V2 ETH-USDC pool going back to September 10, 2022.
By examining the USDC-ETH pool, we can observe the returns generated for liquidity providers. For example, if an LP deposited $1.00, split equally between ETH and USDC, into the pool on September 26, 2022, it would have resulted in a return of -4.79%.
On the other hand, holding these two assets individually would have produced a return of -7.05%. Consequently, in this scenario, taking into account the significant market turbulence during the last months of 2022, it would have been beneficial for the LP to provide liquidity to this pool, leading to a higher relative return.
Improve your use of DeFi and DEXs with on-chain analytics
DEXs are constantly innovating and improving their services for users. As DeFi and DEXs continue to evolve and provide the best user experience while maintaining their unique characteristics, we can expect to see a migration of users and a greater adoption of this new technology.
DeFi is an evolving system that holds great promise. The increasing Total Value Locked is now playing an important role in the cryptocurrency industry. Currently, there are plenty of opportunities to participate in the market and earn returns on your assets. However, it is essential to be aware of the potential risks associated with DeFi, such as high gas fees or permanent loss for liquidity providers on decentralized exchanges.
It is crucial to be aware of these trends and user migrations. Keeping a close eye on the ecosystem can also be beneficial in identifying opportunities to participate in the market and earn returns on your assets.
Frequently Asked Questions
About the author
Pedro Negron is currently a junior research analyst at IntoTheBlock, where he is directly involved in analyzing the most recent developments in crypto. He examines crypto from a data-centric perspective and examines major sectors such as DeFi’s major protocols. Other areas of interest include Bitcoin and NFTs, which are analyzed from a data-driven point of view.
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