The mechanism, risks and opportunities of Aerodrome, the largest DEX on the Base chain

Author: Jack Inabinet, Senior Analyst at Bankless; Translation: Golden Finance xiaozou

Aerodrome is undoubtedly special.

Since its first day online, Aerodrome has been one of the most popular applications on Base L2. The protocol currently hosts $1.3 billion in TVL (50% of all Base smart contract deposits), and its AERO token is the best performing DeFi asset this fall, up 125% since the beginning of September.

Before it began to surge in early September, Aerodrome's TVL had been stable at around $500 million, becoming the main obstacle to AERO's upward price. The token was trading 80% below its all-time high, but then rebounded during the bull run sprint in September.

Today, let's discuss the mechanism of Aerodrome to better understand the risks and opportunities associated with this type of peak exchange.

1. The mechanism of Aerodrome

Like many other decentralized exchanges (DEX), Aerodrome uses automated market makers (AMMs) to provide instant low-slippage trading and one-click liquidity provision profit opportunities for hundreds of cryptocurrencies.

As a "MetaDEX", Aerodrome stands out for its token economics, combining the uniqueness of Curve and Convex liquidity mechanisms with the passive market making technology pioneered by Uniswap. In practice, this produces an AMM exchange based on Base's veTokenomics model, which empowers token holders to direct token allocation to liquidity pools through voting.

Unlike Curve, which only rewards its veCRV holders with 50% of transaction fees, Aerodrome returns 100% of application transaction fees to veAERO participants, who gain greater voting power and higher rewards by locking more tokens. While Aerodrome liquidity providers will not receive any income from token transactions, they can be compensated with inflationary AERO distributions that can be held, sold, or escrow voted.

Through Aerodrome’s incentive market, users can lock crypto tokens as rewards to veAERO voters, who allocate tokens directly to designated pools, resulting in a well-functioning Aerodrome liquidity bribery market and an additional revenue stream for veAERO participants.

Epoch 60 (or the week ending October 23, 2024) was the sixth-highest week on record for total rewards at Aerodrome and the second-highest week by volume, with veAERO lockers earning a net $5.85 million in fees and rewards on $3.63 billion in volume.

2. Investment Notes

Aerodrome token economics encourages long-term oriented holders to lock their tokens in the hope of offsetting AERO's high inflation rate, which is as high as 37% annualized at the time of writing.

Currently, 50% of AERO's supply is locked up, with an average lock-up period of 3.86 years. Due to the limited availability of tokens for sale, resulting in a mismatch between supply and demand, the token can more easily rise due to less buying pressure.

The rise in Aerodrome’s market cap is very reasonable, the increase in distribution value increases the total yield of liquidity providers, attracts new deposits, improves the bullish fundamentals of the protocol, and increases investors’ willingness to pay for AERO!

Unfortunately, while the veTokenomics mechanism can successfully increase token prices and deposits, it also stimulates inherent reflexivity. Despite the stable TVL in April, AERO still fell sharply by 80%, which clearly shows that it is difficult for the market to absorb high-inflation tokens when investor demand shrinks.