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Network effects — the amplification of a platform’s value with each additional user — are the fundamental driving force behind decentralized finance (DeFi) ecosystems, whether for Layer 1, Layer 2, or specific DeFi protocols. This principle necessitates an exhaustive, data-informed growth architecture, concentrating on user acquisition, amplification of trading volume, and liquidity augmentation via laser-focused opportunities. This approach initiates a self-reinforcing growth cycle, enabling protocols to foster resilient and flourishing DeFi ecosystems.

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Securing Volume through Competitive Pricing

Securing an increased market share of organic volume begins with a comprehensive analytics suite capable of dissecting trading pair data, slippage, pricing structures, pool composition, and more across your protocol and competitors’ platforms, including other DEXs and CEXs. Attracting and retaining users in the competitive DeFi landscape is intimately tied to competitive pricing. As users grow increasingly shrewd and cost-aware, they’re naturally attracted to platforms that optimize their returns and slash transaction costs. Hence, a comprehensive understanding of the competitive milieu, particularly the pricing methodologies of Centralized Exchanges (CEXs) and fellow DeFi platforms, becomes crucial.

Layering competitive analytics with your distinctive competitive advantage enables you to understand the dynamics behind the superior performance of other platforms and tactically employ your treasury and team to secure a greater volume share. However, the goal should not only be to increase volume but also to ensure its sustainability; the incremental benefits of volume increase should exceed the associated costs of incentivizing that volume over an extended period.

Paradox: A token issuer should be able to provide deeper liquidity on DEXs on their own protocol

Upon observing the trading volume of Optimism, a layer 2 solution, it is evident that centralized exchanges (CEXs) exhibit higher trading volume than decentralized exchanges (DEXs). This is a paradox given that as the token issuer, Layer 1s, Layer 2s, and DeFi Protocols should ideally be able to provide deeper liquidity on DEXs residing on their own chain.

As seen above, Binance is able to leverage some of its volume to grow its DeFi ecosystem both on it’s L1 (BSC) and its DEX (Pancake Swap), and we believe other L1s and L2s can be a lot more focused on ensuring their token volume settles on chain.

Presently, Layer 1 and Layer 2 solutions and DeFi protocols conduct their token sales primarily on a myriad of CEXs, leading to a significant shortfall in on-chain activity. A fundamental shift in this modus operandi is necessary to stimulate the on-chain economy and token issuers should be adding requirements for settlement on their DEX or chain when setting up these token sales.

To address this, a key step would be migrating some of that trading activity from CEXs to on-chain exchanges. By doing so, we can stimulate a robust on-chain ecosystem, invigorate on-chain perpetual DEXs, and set in motion the domino effect of engaging more lending/borrowing activities within the on-chain context. In essence, the goal is to stimulate the on-chain ecosystem and trigger a cascade of active engagements, such as lending/borrowing and on-chain perpetual DEX trading, thereby fueling the on-chain economy.

The current trading landscape presents a paradox, particularly when considering DEXs such as Uniswap. Despite Uniswap team’s efforts in creating one of the most sophisticated DEXs globally, the bulk of the volume for their own token primarily transacts on CEXs. Ironically, Uniswap v3 only ranks as the 10th most active platform for trading its own token.

In order to comprehend this phenomenon, it’s crucial to examine the competitive dynamics between DEX liquidity and CEXs. This understanding forms the foundation for strategizing incentivization mechanisms aimed at enhancing the attractiveness and efficiency of DEXs. The ultimate goal is to ensure that DEXs offer trade execution for various trade sizes that is as good as, if not better than, CEX execution.

There are a number of reasons why CEXs are out-competing DEXs:

1. Liquidity and Slippage: CEXs often have higher liquidity and less price slippage due to larger user bases and order books. This results in more efficient markets and better trading experiences. DEXs and Layer 1/Layer 2 solutions should focus on incentivization strategies to attract more liquidity providers.
2. User Experience and Usability: CEXs often provide a more user-friendly interface, which is crucial for new users who are not fully acquainted with blockchain technology. They offer simpler processes for account setup, trading, and managing assets. To compete, DEXs and Layer 1/Layer 2 protocols need to invest in improving user interface and experience, making onboarding and navigation as seamless as possible.
3. Speed and Scalability: High-frequency trading is more viable on CEXs due to faster transaction times and the ability to handle large transaction volumes. DEXs, especially those on Layer 1, often struggle with congestion and high gas fees. Layer 2 solutions and other scaling techniques should be implemented to enhance transaction speed and capacity on DEXs.
4. Customer Support: CEXs usually have dedicated customer service teams, which provide immediate help when users encounter issues. DEXs, being decentralized, often lack this support. While it might be challenging to provide traditional customer support on DEXs, they can establish robust online communities and resources to assist users and address their queries and concerns promptly.
5. Regulatory Compliance and Trust: CEXs are typically regulated and must comply with KYC/AML laws, which can inspire trust among certain user groups. While the anonymity of DEXs is attractive to some, it can also be a barrier for others. DEXs could work towards establishing a balance between user privacy and regulatory compliance to attract a broader user base.

Potential for a shift from CEX dominance to DEX dominance

We firmly believe that token issuers can effectively leverage their unique position to improve pricing dynamics by driving deeper liquidity through incentives. The mounting regulatory pressures that are eroding the traditional strongholds of leading centralized exchanges, such as Binance and Coinbase, the emergence of faster, more scalable blockchain technologies, highlighted by the ongoing Layer 2 wars, the recent thrust toward enhancing user experience, with initiatives such as Uniswap’s mobile application, — paint a promising picture.

By exploiting these opportunities, we anticipate an unprecedented surge in on-chain trading volume, fuelling further evolution, growth, and connectivity within the DeFi space to kickstart the DeFi flywheel. It is extremely important to build deep analytics into each of these areas and fight tooth and nail to win volume and outcompete centralized counterparts to win volume for on-chain protocols.

Deeper Liquidity for Better Prices

A platform’s competitiveness and its aptitude for facilitating seamless transactions are significantly hinged on the depth and concentration of its liquidity. In the realm of DeFi, superior liquidity is not merely a large quantity but a well-optimized and concentrated assembly of assets that ensures reduced slippage and more efficient transactions.

An abundance of liquidity, if not properly structured, can still lead to an inefficient trading experience. For instance, if the majority of the liquidity is concentrated in positions that are out of the optimal trading range — as can occur when people provide liquidity to farm airdrops — the result can be increased slippage and less competitive prices, even in a liquidity-rich environment.

Hence, to enhance a platform’s appeal and offer users superior prices, it is not enough to amass a large pool of liquidity. It is essential to manage this liquidity strategically and ensure its concentration in areas that facilitate efficient trading, minimize slippage, and ultimately foster an optimized trading environment. Below are some ways to increase liquidity:

• Crafting Incentive Programs: Crafting effective incentive programs is crucial to the success of bridging liquidity. To do this, you need a robust incentive budget and a deep understanding of what appeals to liquidity providers. At OpenBlock Labs, we support protocols in defining and implementing these strategies. Our collaboration with Lido, a DeFi protocol, involved an in-depth analysis of their incentive structure. By understanding Lido’s user behavior and responses to different incentives, we helped design a program that not only boosted liquidity but also improved user engagement and retention (openblocklabs.com/lido).
• Market Making: Internal market making, using the protocol’s own liquidity, can be a great way to initially bootstrap pools. By using internal liquidity, the protocol can ensure continuous trading activity, reduce slippage, and enhance prices. However, this requires careful management to avoid depleting the protocol’s own liquidity reserves. Partnerships with external market-making entities offer a quick and dirty way to augment a platform’s liquidity. These entities bring inorganic liquidity that helps to bootstrap liquidity pools initially. This external, inorganic liquidity can serve as a stop-gap, helping to attract organic volume to the platform. Over time, as organic volume increases, the protocol can gradually reduce its reliance on inorganic liquidity, shifting towards more organic liquidity. It’s a balancing act that requires careful monitoring of trading volumes, user behavior, and market dynamics.
• Enhance the role of the LP: As liquidity providers (LPs) are essential to maintaining efficient markets, their role should be rewarded. By creating utility for LP tokens, such as governance rights or additional yield opportunities, the cost of providing liquidity can be significantly reduced. This lessens the need for incentives and makes the liquidity provision more sustainable. To do this effectively, it is important to partner with lend-borrow protocols, like Aave or Compound, and work within their requirements to ensure you have the highest supply caps, to increase capital efficiency for your LPs.

The role of Analytics: Decoding the Competitive Landscape

Achieving competitive pricing and winning volume requires a robust analytical methodology. It involves a detailed understanding of competitors’ pricing models, trading sizes, slippage rates, and changes in user behavior over time. This helps to identify high-leverage opportunities and formulate actionable strategies.

1. Unpacking Pricing Structures: The journey to competitive pricing begins with unpacking the pricing structures of competing platforms. This involves understanding how they charge for trades, whether through flat fees, percentage-based charges, or a tiered pricing system. By comparing these pricing models with the size and frequency of trades, it’s possible to see how the competition caters to different user segments, and where gaps or opportunities may exist.
2. Diving into Trading Sizes and Slippages: An understanding of the competition’s trading sizes and slippage rates provides insights into the operational efficiency and liquidity of these platforms. Platforms with larger trading sizes and lower slippage rates are likely offering deeper liquidity, which can result in more competitive prices and better user experiences. Analyzing these factors can help identify what your platform needs to match or surpass such efficiency.
3. Monitoring Behavioral Shifts: In this rapidly evolving industry, user behavior isn’t static. A successful platform must continuously monitor shifts in user trading habits, frequencies, and preferences. For instance, if users are trading more frequently but in smaller sizes, it could indicate a need for pricing structures that favor high-frequency, low-volume traders. Similarly, if users are favoring certain trading pairs or showing a preference for certain times to trade, this could inform your liquidity and pricing strategies.
4. Identifying Actionable Opportunities: From these analyses, actionable opportunities will begin to surface. There could be a niche in the market for a platform that is tailored more to the needs of low-volume traders. Alternatively, there might be a scarcity of competition when it comes to offering competitive pricing for specific trading pairs. These voids in the market present a clear opportunity for platforms to enhance their appeal and differentiate themselves. A more nuanced understanding of the DeFi landscape can reveal underserved or oversaturated areas in terms of product offerings. Different types of DeFi trading instruments cater to different user needs. For example, Perpetual Contracts (Perps) may attract high-risk users, while delta-neutral strategies could be more appealing to risk-averse individuals. By identifying areas that lack variety or have too many similar offerings, platforms can create targeted strategies to offer unique, underserved products or diversify heavily concentrated areas. Furthermore, the inclusion of distinct assets not readily available elsewhere can further augment a platform’s distinctiveness and competitiveness. By catering to a variety of user risk profiles and trading preferences, platforms can not only enhance their user base but also encourage user engagement and loyalty. These factors culminate in a multi-faceted strategy that goes beyond addressing immediate market gaps, laying the foundation for a platform that caters to the diverse needs of DeFi users.

Quick Wins and Transition Functions

By identifying specific routes or volume types that a platform can dominate, protocols can achieve quick wins and boost their market presence. For instance, if a platform’s tokens are being traded more frequently on a CEX or another DEX, creating attractive liquidity for these assets on the protocol can catalyze increased volume.

Simultaneously, strategically transitioning from inorganic to organic liquidity while maintaining volume is critical for sustained growth. OpenBlock Labs works to identify these transition functions with the highest ROI, ensuring the cost-effectiveness of these transitions. These transitions may involve pool bootstrapping, new asset listings, or merging pool liquidity.

Observing, Adapting, and Evolving: The Continuous Optimization Loop

Constant monitoring of trading metrics, such as volumes and slippage, is vital for evaluating the success of the implemented liquidity strategy. Platforms should use these insights to refine their strategies continually, promoting sustainability, effectiveness, and resilience in liquidity management.

Conclusion

Strategic planning and implementation underpinned by a deep understanding of market dynamics, shrewd partnerships, user-centric incentives, and continual performance analysis is the key to bootstrapping a successful DeFi ecosystem.

At OpenBlock Labs, we apply our analytical rigor and professional approach to equip L1s, L2s, and DeFi protocols with the insights and tools needed to carve out a competitive edge in the DeFi landscape, contributing to the evolution of finance itself.

About OpenBlock Labs

OpenBlock is a platform that empowers Web3 organizations with the data intelligence needed to take action and drive growth. From managing grants to optimizing incentive spend, leading DAOs and blockchain networks utilize this technology to maintain billions of dollars in value within their ecosystems.

If you are interested in working with OpenBlock Labs, please visit us at openblocklabs.com or reach out via Twitter at @openblocklabs.