Last week, a new to-be-launched decentralised exchange called SushiSwap started to make headlines in the cryptocurrency industry. The industry is plagued over the weekend hit-and-run projects, so having a clone project from anonymous authors making a long term impact is unusual. However, this time the trading games named after Japanese cuisine are making a hocket stick blip on cryptocurrency radars.

No alt text provided for this image

The royal

Currently, the number one decentralised exchange is Uniswap. Uniswap is based on so-called bonding curves and not traditional order books. Basically, as a market maker, you provide liquidity by depositing assets. Assets include stablecoins (USDT, USDC, DAI), ether (ETH) or any, tokens (LEND, COMP). Then the price is automatically set for you. This method is

  1. Simple, as even your grandma can become a liquidity provider - all you need is to deposit
  2. Fair, as all market makers are equally treaded - shorter cables or faster computers do not make more profit

On a bonded curve exchange, liquidity providers make money if the asset price (base token, quoted token) is relatively stable. If either of trading pairs makes sudden, permanent, moves then the liquidity providers lose as they would have made more profit by justing holding the asset.

Uniswap was originally developed with a grant from Ethereum foundation. They are rumoured to raise tons of venture capital over this summer. The team is based in New York. The current version, Uniswap v2, is a massive success, having half a billion trading volume as writing this on Monday morning.

No alt text provided for this image

The usurper

The downside of Uniswap is that there is no long term benefit for liquidity providers. You only make a profit as a liquidity provider as long as your deposits are in. You do not reap any of the long term benefits of bootstrapping a DeFi ecosystem and being an early adopter. There is no sustainable funding model for development, governance or, what everybody is dreaming of, profit sharing.

The value promise of SushiSwap is simple

  • Clone Uniswap.
  • Offer equity in the form of SUSHI tokens that can be used for revenue sharing and governance (even if there is no revenue sharing at the start you can simply vote it in). Note that this is not company equity in the traditional sense, but decentralised equity in the form of you have voting weight over the smart contracts. No corporate laws apply here.
  • Treat everyone equally, there are no private deals for venture capital funds or others, everyone is on the same starting line when the game starts.

Revolutionary challenges

There are two major problems to start a decentralised exchange with an equity token

  • How to distribute the original SUSHI equity tokens?
  • How to bootstrap liquidity for the SushiSwap exchange?
A photo by Macau Photo Agency

Let's look at the distribution problem first. There are legal and fairness aspects of having equity distributed.

The legality of profiting from decentralised exchanges

SushiSwap authors do not want to get into hot water by providing unlicensed exchange services. In 2017 in the US, the founder of EtherDelta decentralised exchange, Mr Zach Coburn was sued by the SEC for violating the Securities Exchange Act of 1934. Zach settled without admitting or denying any wrongdoing for $300k. This send a warning for everyone that the SEC is actively looking into this space and will go after people if they think they can.

As far as I understand why the SEC has not gone after Uniswap, a New York-based team well within their reach, is that Uniswap team is not currently profiting from their venture. Zach was making a profit on his sole developer account on EtherDelta.

The part "if they think they can" is the important one. If the control of the exchange is "sufficiently decentralised" it is very hard for the SEC to take down it. Even if you sue one or two equity token holders here and there, as long as the governance tokens that allow vote in exchange upgrades are widely distributed, the SEC or anyone else cannot effectively stop it. If you cannot stop it then it is sufficiently decentralised.

Fairness of equity token distribution

Everyone hates making rich people richer. A lot of crypto projects (wink Compound wink) fund themselves by initially selling tokens only to professional investors like venture capital funds. The mutual incentive here is that the project gets easy money and the professional investors also get easy money as soon as they get the first opportunity to dump their bags on retail investors. No one likes this kind of preferential treatment where you do not get access to the deal just because of who you are.

Dry rivers do not attract traders

There are from hundreds to thousands of crypto exchanges in the world. Most of them are not profitable. There are not enough traders using them. Traders won't use them because there is not enough liquidity. There is no liquidity because there are no traders. All new exchanges face this chicken and egg problem. The usual approach to overcome is that you are either first to market (no competition, liek with early Coinbase and Kraken) or you just have more money than everyone else and use your own capital to provide liquidity (FTX)

Coup d'état

All three problems "sufficiently decentralised", "fairness of distribution" and "lack of liquidity" will be solved by the same tool. This tool is called yield farming.

A photo by Gabriel Jimenez

Yield farming is an activity whereby providing liquidity to a system you are rewarded not just yield or interest of the asset but also with third party tokens.

Yield farming was first piloted by Synthetix, a market place for synthetic assets. It is also made popular by Curve, a stablecoin exchange and YAM, an elastic supply stablecoin.

Yield provider makes a limited duration offer for the farmers

  • Provide liquidity by depositing assets to providers' systems or third party systems
  • Earn interest and earn equity tokens
  • Because there is a limited amount of equity, this offer is valid only for the limited duration, causing Fear of Missing Out (FOMO)

The innovation of SushiSwap is that

  • You earn SushiSwap SUSHI equity by providing liquidity to some of the popular pools on Uniswap - something market makers do in any case.
  • This equity will give you rights for revenue sharing when the SushiSwap exchange launches.
  • Because market makers only care about making more money and if one can earn both yield plus revenue share on SushiSwap, it makes sense to move your liquidity over as your net yield will be higher.
  • By distributing equity tokens through active work, not by sales, you have a much higher degree of decentralisation and a much higher ground on any legal arguments of securities laws - at least you were not doing an illegal capital raise.

I call this a vampire attack on liquidity. You suck it out one other system and move over to the other by giving a better long term deal.

A photo by Macau Photo Agency

End game

Traders are slimey and slippery creatures, having their loyalty is hard and fighting is fun. I consider Uniswap vs. Sushiswap the second great battle of DeFi wars - the first one was COMP vs. YFI over the control of Curve profits.

SUSHI-ETH became the most voluminous trading pair on Uniswap over the weekend. SUSHI token distribution will run for two weeks. SushiSwap exchange will launch in the near future. Will it become the new number one and replace Uniswap? If SushiSwap fails to launch well, Uniswap will be super happy of all new millions of trading volume the gamification of limited SUSHI token offer brought it.

No alt text provided for this image

As pointed out by Martina Krung on Twitter, neither liquid nor illiquid liquidity is loyal. When there is a better yield from somewhere else, the whales will move their tokens over. Can SushiSwap capture enough value and lock the liquidity of equity token holders so that it become viable long term?

Andre Cronje hopes this event does not change the crypto ethos and start pushing things more closed source. Because it is so easy to launch a clone project with better terms, there is no protection for your innovation. Only the current best profit matters for users and investors. Making things closed again breaks composability of decentralised finance legos and would end the Cambrian explosion of DeFi we are witnessing today.

We are seeing an outflow of tokens from centralised exchanges, as our primordial DeFi ecosystem is finally on something. But unlike other cryptos, bitcoin price has not pumped with DeFi rally. Bitcoin hopped off from the innovation train already back in 2013 - when the last successful Bitcoin feature, the multisignature wallets, were added. If you hold bitcoin now would be a good time to consider if the sound money argument is the only argument you should listen to and distribute some of your holdings over more innovative cryptocurrency projects.