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Posted on Mar 14, 2022Read on Mirror.xyz

DEX Aggregators: The Future of On-Chain Trading

Author: Amidzic Momir @ IOSG Ventures

The data analyzed in the article refers only to the Ethereum on-chain activity.

Drawing a parallel to Web 2.0. Why do we need aggregators?

One thing that is consistent across both Web 2.0 and Web 3.0 is the demand for products and tools that improve convenience for the end-users and reduce the cost of finding the right product and service.

For example, Amazon has built an empire by creating a convenient experience for customers to purchase goods and services online, optimizing the cost and delivery time, while creating a global marketplace that benefits both buyers and sellers. Lowering the barriers of entry and increased competition goes at the expense of traditional business models, however, benefits the general economy as it increases productivity and purchasing power of the retail customers.

In the parallel world where Amazon-like applications don’t exist, customers looking to purchase a particular product online would have to browse through different stores, interact with multiple frontends, spend time to compare the prices and quality offered by different providers, etc.

For similar reasons customers prefer to interact with Amazon rather than individual stores, Web 3.0 users prefer interacting with aggregators rather than individual smart contracts. The more complex the on-chain spectrum becomes, the larger the demand for the aggregator layer.

The main functions of aggregators

Essentially, aggregators perform two simple functions:

  • Search convenience
  • Execution quality

The former one refers to the situations where some user may be interested in purchasing a token that is not necessarily listed on the exchanges he/she is used to interacting with. Instead of repeatedly going through the process of finding the venue where new tokens are listed, a user can simply skip this step and purchase any on-chain token through Matcha or a 1inch-like aggregator.

Not only that these engines help users find the newly listed tokens, but also ensure any transaction is executed in an optimal way.

For example, below is a transaction executed through 1inch. Instead of simply exchanging more than 20 WBTC for USDC in one transaction, 1inch did the conversion through multiple exchanges, several hops including four different tokens, in order to provide the trader with the optimal slippage and gas fee.

https://etherscan.io/tx/0xe1d77f0a443f1ae130ec82b6f05f4675e735cc36a05cf629a29d12fc4250b473

The example above illustrates that aggregators are particularly useful for whales. This should not be neglected, considering that whales are facilitating almost 90% of the on-chain volumes, despite representing less than 4% of DEX users.

Source: https://dune.xyz/momir/DEX-Users

Source: https://dune.xyz/momir/DEX-Users

At present, how significant are the aggregators?

Source: https://dune.xyz/queries/428905

As illustrated above, roughly 20% of monthly on-chain volumes have been generated through DEX aggregators, with a clear growth tendency. This figure is even more significant knowing that aggregators mainly represent non-bot volume (more than 70% of aggregators’ volume is generated by non-bot traders). On the other hand, bot volume accounts for roughly 50% of the total on-chain volumes, implying that almost 1/3 of the trading volume generated by ordinary traders already goes through DEX aggregators.

To support this claim, we use trading frequency as a proxy for bot trading. The assumption is that bots are trading much more frequently than ordinary traders, thus we believe it is reasonable to assume that addresses trading less than 25 times a day are most likely ordinary traders, while it is relatively safe to assume that the others are bot traders.

Following this classification, as shown in the pie charts below, about 73.2% of the aggregator trading volume is generated by non-bot addresses. On the other hand, around 53.5% of the total on-chain trading volume is due to non-bot trading.

Source: https://dune.xyz/queries/458637

Source: https://dune.xyz/queries/429061/817641

Who are the leaders in the aggregator space?

Prior to comparing the performance of different DEX aggregators, we shall reflect on the difficulties in benchmarking them.

As aggregators are using a different methodology to record the on-chain data it would be wrong to compare their performance prior to standardizing metrics.

For instance, a user may choose to buy $1000 worth of ETH, however, due to the hop trades this trade may generate more than $1000 volume. As a result, we have two different approaches to measuring the volume:

  1. Some aggregators would measure the volume from the user perspective only, or in the above example, they would account for $1000

  2. The others would account for all the hop trades as their volume

Since we are concerned with the potential business models, pricing power, and revenue potential of aggregators, we standardize the data according to the first method. The reason is that aggregators will be able to monetize only the volume that is user-generated, whereas hop trades will be outside of their pricing scope.

Therefore, we first attempt to clean the data for the aggregators having somewhat inflated metrics. Then, we make a distinction between protocols such as 1inch, 0x API, and Paraswap vs end-user-facing products such as Cowswap, Metamask, and Matcha.

The former group of protocols, besides offering the API for various applications to interact with DEXs, also build applications themselves. Hence, 1inch and Paraswap support a frontend under the same brand name, while 0x created another brand Matcha which is relying on 0x API to facilitate trading activity.

While it is possible to differentiate between Matcha activity vs total 0x API activity, at the moment it is not possible to differentiate the activity of 1inch API vs 1inch frontend, or Paraswap API and Paraswap frontend. As such, when we refer to 1inch and Paraswap in the following text, it assumes aggregate activity generated through their APIs.

0x API, 1inch & Paraswap

On a high level, 0x API, 1inch, and Paraswap provide channels for end-user-facing applications to easily connect to the on-chain liquidity, as well as optimization algorithms focused on finding the best terms for individual trades.

As illustrated below, in terms of the user number, 1inch has generally been the dominant player. However, since December, 0x API has been attracting a larger number of users than 1inch API. On the other hand, losing the dominance in terms of the user number hasn’t affected 1inch’s position as the aggregator with the largest trading volume, indicating that larger traders i.e. whales still prefer using 1inch.

Source: https://dune.xyz/queries/262785/805765

Source: https://dune.xyz/queries/262785/805732

Source: IOSG Ventures; Data Source: Dune Analytics & Coingecko

Metamask Swap, Matcha & Cowswap

While Metamask, Matcha, and Cowswap have different underlying mechanisms we benchmark them against each other as they are all end user-facing. For the purpose of this analysis, it is enough to note that Metamask and Cowswap can be thought of as meta aggregators as they are utilizing all of the existing APIs, as well as the primary liquidity sources. On the other hand, Matcha is a project incubated by 0x, thus it is primarily a front-end to the 0x API.

As illustrated below, the results are quite peculiar. Metamask’s user base is far beyond any other end-user-facing aggregator in the space, however, Metamask’s trading volume is consistently lower than Matcha’s, suggesting a significantly different user profile.

Source: https://dune.xyz/queries/262785/811814

Source: https://dune.xyz/queries/262785/811810

Source: IOSG Ventures; Data Source: Dune Analytics & Coingecko

We dive deeper to understand the average user of Matcha vs Metamask. As presented below, Matcha volume is driven by whales, where we classify whales as those trading more than $100k on a daily basis. On the other hand, Metamask has less reliance on whales, where most of the volume, generally, comes from small and medium traders.

We find that Matcha’s largest 10, 25, and 50 users generated roughly 35%, 47%, and 58% of the total Matcha volume over the past 30 days, respectively, with one address alone (Tetranode) generating roughly 17% of the volume during the same time period. When it comes to Metamask, the top 10, 25, and 50 users account for approximately 10%, 15%, 19% of the total Metamask Swap volume over the past 30 days.

Source: https://dune.xyz/queries/426331/812633

Source: https://dune.xyz/queries/300820/571179

Which user base is more desirable?

The fact that power users are choosing Matcha over Metamask speaks in favor of Matcha, however, from the monetization standpoint, Metamask has a more desirable user base. In more detail, Metamask volumes are more healthy as there is less reliance on a small number of addresses. Moreover, power users are likely much more price-sensitive than ordinary users, hence it may be harder for Matcha to maintain current volumes if it introduces unreasonably high fees.

Metamask, being the most popular Ethereum wallet, has a larger moat than any other user-facing aggregator in the space, thus their ability to charge relatively high 0.875% transaction fees. However, the question remains whether with such a business model it can scale Metamask Swap to millions of users and generate volumes on a similar scale to some of the larger CEXs.

The risks for the DEX aggregators

Uniswap.

Uniswap has been the dominant on-chain liquidity source even prior to the introduction of v3. Nevertheless, since v3 deployment the market share of Uniswap in certain months has almost reached 80%!

Source: https://dune.xyz/queries/443564

For a large number of pairs, Uniswap v3 is offering the best pricing. Furthermore, Uniswap has implemented smart order router which executes trades across several pools in order to optimize the final price while ensuring the extra gas cost doesn’t outweigh the benefits.

Hence, it adopts similar logic as aggregators with a more limited tradable universe. However, in a scenario where Uniswap takes 80% of on-chain volumes and still has a growing tendency, are aggregators necessary?

How much of the volume aggregators source from Uniswap?

Looking at the liquidity sources of some of the larger aggregators such as 1inch we can see that Uniswap accounts for up to 60% of the volumes, with other significant players being Curve, Sushiswap, Balancer, and DODO.

We can read this data as follows: despite the chart confirming Uniswap is the most competitive liquidity source, it suggests that more than 40% of times users would lose value if they were to interact with Uniswap directly instead of using DEX aggregators.

Moreover, we should bear in mind the fact that aggregators’ smart order routing engines do not yet take into account MEV-generated slippage in their calculations. With the upgrade in the routing logic, it is expected that the volume exported to the slippage-free liquidity sources such as RFQs increases significantly at the expense of AMMs.

Source: https://dune.xyz/queries/16257

The best-case scenario

In summary, the fact that there exists one dominant DEX does not neglect the need for DEX aggregators. On the other hand, a complete monopoly of one DEX would bring into question the value of aggregators, however, it is almost impossible to imagine such a scenario realizing in practice considering the open-source character and low barrier of entry in the crypto space.

Quite the contrary, it is likely that the on-chain environment will keep getting more complex, creating additional value accrual potential for the layers abstracting the complexity for end-users.

As mentioned earlier, the improvements in routing technology should favor alternative liquidity sources e.g. RFQs. Besides, cheaper chains and rollups could benefit the development of the RFQ mechanism and hence create even more fierce competition at the primary liquidity layer. The reasons are twofold.

  1. On rollups, market makers will be able to quote more aggressively than on Ethereum due to the faster block finality.
  2. Rollups and cheaper chains are expected to create a positive feedback loop, increasing the on-chain order flow and attracting more market makers to participate in on-chain trading through the RFQ mechanism.

The first point is relatively simple, as RFQ guarantees zero slippage, the longer it takes to settle the transaction the more risk market makers have to assume, thus Ethereum Layer 1 requires the quotes to be much more conservative than what would be possible on Layer 2s.

As for the second point, a more extensive explanation may be required. Namely, once the gas fees are less of a problem we should expect a larger number of the end-user-facing applications connecting to aggregators’ APIs.

That is to say, we may see an increasing number of localized, centralized, and compliant frontends customized for different geographies that source liquidity through decentralized sources — aggregators’ APIs.

These apps would be analogous to the regional centralized exchanges, with the difference that launching such an app is relatively easy as there is no need to worry about underlying infrastructure but focus solely on improving UX and creating a loyal user base.

The increasing order flow routed to aggregators’ APIs will create an additional incentive for market makers to plug into the RFQ mechanism, further improving the pricing and competition among primary liquidity sources.

Moreover, not only that scalability solutions will lead to more competition at the DEX layer due to the above-mentioned dynamics, but also the anticipated decrease in gas cost would allow aggregators to split a trade between various sources at negligible cost, further enhancing the value proposition for the end-user.

In summary, all these factors are expected to strengthen the positioning of aggregators as critical pieces in the on-chain trading hierarchy.

It is not hard to imagine a future where a large majority of the manual traders rely on DEX aggregators such as Matcha, 1inch, Cowswap, and other similar applications to execute the transactions, making DEXs a backend that should be focused on capital efficiency while aggregators take care of UX. Looking at the current landscape, this is probably something resonating the most with Curve.fi vision.

Curve.fi UI Design

In this layout, aggregators could become even more valuable than the dominant liquidity sources, having a presumably loyal user base willing to pay the convenience fee, while primary liquidity sources engage in a race to the bottom to attract the order flow.

Acknowledgments:

Thanks to the 0x Labs team for providing valuable feedback.

Disclaimer:

0x Labs, Consensys and 1inch are IOSG portfolio project.

🦄 About IOSG

IOSG Ventures, founded in 2017, is a community-friendly and research-driven early-stage venture firm with offices in China and Singapore. We focus on open finance, Web 3.0 and infrastructure for a decentralized economy. Our portfolio covers more than 60 projects, including Layer 1 (NEAR, Polkadot, Cosmos), DeFi (1inch, Synthetix, UMA, Dodo, Liquity, Gelato). We commit ourselves to work alongside various developer & DAO communities and helping the most aspiring founding teams to achieve success. As a developer-friendly fund with long-term values, we have launched Kickstarter Program which offers capital and resources for innovative and courageous developers. Since we consistently cooperate with our partners and connect with communities, we work closely with our portfolio projects throughout their journey of entrepreneurship.

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