Uniswap, SushiSwap and 1inch: what does the future hold?

Welcome to the Kingdom of Decentralized Finance (DeFi) and Decentralized Exchanges (DEXs). The Kingdom where computer code and human community are equally important to carry the crowns of the Kings.

Whereas Bitcoin, Ethereum and Centralized Exchanges (CEXs), such as Binance, Kraken, to name a few, were the undisputed Kings of crypto for nearly a decade, the playground has been changing exponentially for the last few years. The new players, armed with Automated Market Makers (AMMs) have entered the battlefield to further take the crypto and finance space to the moon.

In this new playground, liquidity is what the DeFi soldiers are fighting for, and liquidity tends to attract more liquidity. The guns are the strength of the community, the Liquidity Providers, whilst their food is the rewards they get and the code of conduct is governed by stakeholders and smart contract code.

So far, Uniswap has been the so-called King of DeFi. At the time of writing, the liquidity of this DEX has topped an all-time high: nearly $4 billion ($3.99 bn to be precise) Its copy-cat, SushiSwap has also reached its all-time high of $3.16 bn. Which of those will take the crown of the King of DEX? What do these DEXs do to differentiate from each other, and where does the leading DEX aggregator, 1inch, stand to compete- or to complement them?

The beginnings: Uniswap

Uniswap has undoubtedly paved the way for the explosion of the DEXs. Although attempts to operate a decentralized exchange that would enable swapping tokens without an intermediary were made before, Uniswap has taken these efforts to another level. By enabling token pools on-chain and enabling users to trade against the reserves, Uniswap has solved the liquidity problem of DEXs, which is by far still the most significant concern for them. In order to make the users feel motivated to contribute to the pools, Uniswap rewards them with reward fees: The DEX charges 0.3% fee per trade, with the fees immediately being deposited into liquidity reserves and split by Liquidity Providers, LPs, based on the ratio of their pooled tokens relative to the entire pool supply.

SUSHI and UNI

Here comes the end of August, 2020 and a clone of Uniswap- SushiSwap- is launched. Albeit being nearly identical products, SushiSwap presented a new dish on the table- a SUSHI token as a reward for LPs. At the beginning of its operations, SushiSwap offered its SUSHI token for users who staked liquidity tokens into few Uniswap liquidity pools, generating $1 billion liquidity in just four days. Whilst the fight for the users was on-going, Uniswap launched its own token, UNI, and rewarded the early adopters of the Uniswap protocol with 15% of the token offer. The UNI tokens did not and do not directly support the liquidity of the Uniswap protocol, however many projects still continued to use Uniswap as their primary trading venue and continued to encourage the community to provide liquidity to their respective Uniswap pools.

Governance

So what do the tokens mean and what do they encourage? Decentralized Finance and Decentralized Exchanges, as the names suggest, stand for decentralization as a concept. Meaning, that by definition, the control of the protocols and the trades should not be governed by a centralized party, but in contrary- by community and by computer code. Centralized Exchanges must comply with Anti-Money-Laundering and Know-Your-Customer (AML/KYC) rules in order to ensure that the funds do not come from illicit sources. The DEXs, for now, do not have such rules, and as per definition, they are not/ should not be controlled by one entity. To reiterate, control of the protocol by the community and by computer code, in these days of DeFi, is the strongest indicator of the decentralisation of the protocol. Therefore, in the long run, it makes sense to have a decentralised token distribution, accessible to all participants of the protocol, rather, than distributing the tokens to the so-called whales. Why? Because the whales can leverage their holdings and power in a way that benefits themselves, not the stakeholders and the community.

Now, analysing the governance of the two competing DEXs- Uniswap and SushiSwap- it is important to look at the governance mechanisms. Uniswap did not have governance before the release of the UNI token: the changes to the protocol were decided by the team. The founder of Uniswap is Hayden Adams who took a grant from Ethereum Foundation and raised money from VCs such as Andreesen Horowitz, Paradigm VC, Union Square Ventures and ParaFi.

After the UNI token was introduced, the initial supply was distributed to traders and liquidity providers who have previously interacted with protocol. According to the Uniswap plan, the token distribution will be 350 million UNI to the community treasury, team, investors and advisors in the 1st year, followed by 250 million in the 2nd, 150 million in the 3rd and 100 million in the 4th year.

What concerns the governance of the Uniswap protocol any governance proposal to be submitted requires 10 million UNI tokens and to pass it requires 4% or 40 million UNI tokens voted in favour and a majority vote. During the first Uniswap governance vote, the top two addresses holding 15 million UNI each accounted for 98% of the votes. Does this suggest that the protocol might be not decentralised at all? Perhaps, it is too early to make any conclusions, especially at such an early stage of DeFi ecosystem development. Uniswap is launching a Version 3, in which Hayden Adams promised ‘to fix everything’, although we are kept in the dark of what it means.

Let’s look at the SushiSwap plate and how its tokens are being distributed. SUSHI reward tokens are earned by providing liquidity. Does SushiSwap win Uniswap in this regard? Well, by distributing tokens through participation in the project this suggests a higher degree of decentralization. Growth of liquidity mining as a valid method for token distribution is leveling up the playing field for everyone involved in the protocol: the tokens are equally distributed based on the amount of liquidity provided.

The governance of the SushiSwap is in the hands of the SUSHI token holders. Anyone can submit a SushiSwap improvement proposal, on which SUSHI holders can vote. Strong and motivated community is very powerful, especially in DeFi, and protocols continuously have to answer a question of how to distribute tokens to make the network as decentralised as possible. Therefore, by distributing SUSHI tokens to SushiSwap LPs, SushiSwap not only incentivizes them but also pushes for the decentralization of the protocol.

Impermanent Loss and 1inch

As mentioned earlier, liquidity is key for the DEXs and traders always move where the yield is better. How do projects lock the liquidity, are there other ways to incentivize the LPs? Mooniswap- the Liquidity Protocol by 1inch has figured out a way.

Mooniswap by 1inch believes that one of the main problems of Automated Market Makers like Uniswap and SushiSwap is the impermanent loss for LPs. By definition, Impermanent Loss is when an LP has a temporary loss of funds because of volatility in a trading pair. In DEXs, when the value of one trading pair moves, this creates an immediate arbitrage opportunity for arbitrageurs, but also an Impermanent Loss for the LPs.

1inch has created a solution that enables LPs to catch a portion of the price slippage profits that are otherwise captured by arbitrageurs. Therefore, Mooniswap enables LPs to double up as arbitrageurs. The way the 1inch Liquidity Protocol does it is by introducing a 5 minute delay factor, instead of allowing for a liquidity pool to rebalance automatically.

1inch, being the largest DEX aggregator in the DeFi market today, has set its goals high and seems to also focus strongly on community and the power of decentralized governance. Enjoying the success of its DEX aggregation service, 1inch has launched its own token at the end of December 2020, announcing that with the launch of the 1inch token, the protocol will be governed by a DAO (Decentralized Autonomous Organisation). 1inch token is intended to be used for allowing the community to vote for specific protocol settings under the DAO model, in a transparent, user- friendly and efficient way. The token will be used in all current and future protocols within 1inch Network, starting with the 1inch governance Aggregation Protocol and the 1inch Liquidity Protocol governance modules.

What concerns 1inch Aggregation Protocol, a new feature that was introduced is to allow for the 1inch token holders to vote on the settings of so-called Surplus Pool, which accumulates leftovers of the swap transaction when the price of the swapped tokens changes during the time of transaction. The Spread Surplus will initially be set to 0%, with all Surplus going to referrers. This can be changed via 1inch governance and the Spread Surplus can be claimed by governance participants and referrers in 1INCH token.

With regards to 1inch Liquidity Protocol- formerly mentioned as Mooniswap- the 1inch token will be used to vote for a number of parameters: the price impact fee, the swap fee, the governance reward, the referral reward, and the decay period.

In order to vote, a token holder has to stake its 1inch token and the LPs can participate in governance of their pool directly with their LP tokens. The way of how the votes are calculated is by using a weighted average of all votes, whilst the weight of each user’s vote is proportionate to the amount staked. This is how one of the key players in DeFi and DEX market is viewing the importance of community engagement and the impact of tokens on decentralization.

DEXs and CEXs

What are the ways to encourage the participation of the crypto community in providing liquidity to DEXs and increase the market share? Today, it can be arguably said that the majority of DEXs users are sophisticated crypto users that do not mind to navigate sometimes seemingly complex user interfaces and understand the staking options. The Centralised Exchanges, CEXs, are much more user friendly and often guide the users by hand in order to introduce them to the novel products and projects. What if DEXs and CEXs join forces?

This is what SushiSwap has offered on the plate for 2021: introducing Mirin, a version 3 of the SushiSwap protocol. As its name, Mirin, the liquid sauce used in Japanese cuisine, it is intended to add- you guessed it right- liquidity to the SushiSwap ecosystem. SushiSwap says that this ingredient will see the protocol liquidity jump by 10- 20 times. How? By partnering with CEXs. It had already shown the first steps by partnering with the leading CEX, Binance.

What SushiSwap is intending to do is launch so-called Franchised Pools and Sub Pools. By partnering with CEXs through Franchised Pools, SushiSwap is launching the LP Expansion Program. How this programme is intended to work is for CEX becoming a Franchised Partner of SushiSwap, which in turn serves as a gateway to offer high interest bearing tokens for the users of CEX. When a new liquidity pair is added to a CEX platform, a SubPool is created. SubPools are technically separate: users that add liquidity to one SubPool can only withdraw from that pool. However, when calculating total liquidity of SushiSwap, the liquidity of a SubPools is added to the Main Pool of SushiSwap. With the launch of SubPools in various CEXs, therefore, the total liquidity of SushiSwap is expected to increase by multiples- as planned.

Why should this be attractive for the CEXs? As a Franchise Partner, a CEX can charge users transaction fee between 0.05% and 10% for providing a user an extra revenue source. Therefore, CEX can offer users high, stable returns for their assets while retaining the custody of the assets, which is the optimal solution to CEXs biggest worry- the loss of the volume. Moreover, the novelties introduced by Mirin offer double yield- meaning that users earn yield on both pairs of the staked tokens. The protocol allows for an additional third-party governance token of the participating exchange to be distributed as a reward for taking part in their exchange-backed pool. This way, users are able to earn double yield in the form of two separate protocol tokens.

As we can see, although the DeFi and DEX ecosystem is still at its infancy, innovation by the key players is ripening well and we should expect substantial developments that will take the projects and the products further. What has been mentioned in the last paragraph- the collaboration between the blockchain ecosystem is also key for the whole market to flourish, hence one more important aspect that needs scalable solutions is interoperability and interconnectedness of the blockchain networks. The players of the DeFi market know this well, and many are connecting or exploring partnerships in order to make this happen. For instance, SushiSwap has announced that it intends to become a cross-chain Automated Market Maker by connecting with Rune (Cosmos) and Moonbeam (Polkadot), while 1inch has already joined Gravity network in order to connect with non-Ethereum ecosystems.

2021

So who carries the crown of DEXs today? Whilst Uniswap wins SushiSwap by the Total Value Locked today, will it be able to keep this position in 2021?

What about 1inch, will its DEX aggregation capabilities win over and reduce the reliance for liquidity from Uniswap and SushiSwap? It is no secret that a large order at Uniswap is reducing the profits with slippage. 1inch has a solution to find the best deal for its users: not only it has limit-orders, it also has an advanced routing that enables the conversion of tokens through any number of DEXs. 1inch splits a swap across multiple liquidity protocols and also employs its Pathfinder algorithm that utilizes multiple market depths within the same protocol, which gets the user the best fees and takes into account gas fees.

Needless to say, the topic of the sky-high Ethereum gas fees has dominated the headlines of DeFi last year, and everyone is anticipating the successful adoption and development of Layer 2 (L2) solutions that will enable to solve the gas problem. L2, or off-chain solutions, is nothing new- it has already appeared in Bitcoin blockchain as the Lightning Network. Notwithstanding, the implementation of L2 has never been of such importance as it is today with the development of the DeFi ecosystem.

What concerns Uniswap, it is much expected that it will introduce L2 in its Version 3. Uniswap has committed to test Optimism Rollups as its Layer 2 solution.

In contrast, SushiSwap has indicated the adoption of ZK-rollups as the preferred L2 solution. Clearly, neither of these L2 solutions have proven to dominate the space yet, only that both promise to increase the processing speed to +20,000 transactions per second. Therefore, it remains to be seen how the implementation of L2 will develop, but certainly, the first ones to implement will reap the largest market share.

The kingdom of DEXs is being built at the rapid speed, and although the competition might result in the crown changing hands, there is no doubt that this is beneficial for the users, for the community. What is crucial is to continuously increase liquidity for the DEXs and attract new users. Solutions: reduced gas fees (L2), cooperation with CEX, or, perhaps even fiat on-ramps to DEXs?

See you in Layer 2!