Decentralized Derivatives’ Rise Is Inevitable

FionaHe
FionaHe
Sep 2 · 8 min read

Special thanks to the amazing advice/comments/support from MapleLeafCap, Jeff Ng, Jinze, 0xminion, Nicola Santoni, Charles, Leo Yeung, and the A&T Capital team!

Takeaways:

  • dYdX’s token issuance accelerating the replacement of centralized derivatives, showing a pumping Dex / Cex Ratio of derivatives. I see at least 20x potential of trading volume, as derivatives should act as the same of Dex / Cex Ratio of spots.
  • Perpetuals are the most popular decentralized derivatives just as in centralized space, with US$47B accumulative trading volume today, 92 times¹ the figure of Options volume, the latter of which is more for high-skilled gamblers to hedge the risk.
  • I simplify 2 types of liquidity models for derivatives: “Peer to Pool” (Perpetual Protocol, Synthetix, etc.) or “Peer to Peer” (dYdX, etc.). The first one allows freely derivatives listing, lower liquidity requirements; The latter one has less platform risk, higher leverage tolerance, and various order types (Fortunately, Uniswap V3 actually makes limit order and more order types possible.)
  • I love vAMM design! vAMM is only for price generation, while it separated the liquidity pool out to mitigate the impermanent loss for stakers. Unlike AMM design (say, Uniswap), one-token staking makes positions hedged and cut a lot of profit loss for stakers. While Uniswap stakers bear all the profit loss for their positions because they are traders as well for the pair staking.
  • I see perpetual projects using “Peer to Pool” design such as Perpetual Protocol are the improved versions of Synthetix in the way of better UIUX and higher capital efficiency, etc.
  • I projected FDV for dYdX would be ~US$11,451 Million by initiating FDV / APR ratio. Given dYdX’s total supply of 1,000,000,000, per dYdX token price should be ~$11.45. Interestingly, the estimated figure is not too far from reality: the estimated FDV of Perpetual Protocol is US$2,801 Million, while the market figure is ~US$3,010 Million, as of Sept 1, 2021.

Macro factors are pushing: (Pass this part if you already know that DEXs are the future!)

  1. Stricter regulation on centralized derivatives. Binance recently shuts down derivatives trading offerings in Hong Kong, Germany, Italy, and the Netherlands. BitMEX, which was once the largest derivatives exchange, recently was required to pay $100 million penalty to settle the charges with CFTC and FinCEN. Traders in more regions are beginning to turn to decentralized derivatives.
  2. Centralized exchanges are too powerful and less innovative. Due to the custody of user assets and the sole possession of transaction data, we see a lot of “emergencies” such as suspend withdrawals, freezes, downtime, etc. Even worse, centralized exchanges may treat trading data abusively. Robinhood has previously accused that its main business model is to sell customer orders to high-frequency traders, so it benefits from leaking customer information. Centralized platforms have been difficult to gain users’ trust.
  3. Layer 2 is making things work. In August, dYdX’s trading volume is 55 times² the figure in March with the fact that Layer 2 perpetuals went live in April. Perpetual Protocol will soon launch its V2, Curie on Arbitrum, so as Futureswap’s V3. Decentralized exchanges are poised to replace centralized exchanges.

Two inside signals are showing:

Among all the derivative products in this space, perpetual contracts are currently the most popular ones with the largest trading volume. They are developed on the basis of delivery futures with no expiry date. Therefore, it is characterized by a funding rate mechanism, which is to prevent the price from deviating from the spot price and avoid becoming a pure gambling tool.

Dex / Cex Ratio

In 2021Q1, the transaction volume of centralized perpetual contracts exceeds US$14 trillion³. While in the same period, decentralized perpetual contracts generated US$7 billionvolume, which counts for 0.05% of centralized transaction volume. At the moment, decentralized perpetuals account for 0.5%of the monthly transaction volume of centralized ones, 10x the figure in Q1.

In the spot market, this figure is 10%. That means decentralized derivatives trading volume would still go up at least 20x, even given no growth on centralized derivatives.

Data Source: CoinGecko, as of August 31, 2021. Note: Cex data includes Binance Futures, Huobi Futures, OKEx Futures, FTX derivatives, Bybit Futures.

Token Launch Effect

I believe that the issuance of platform tokens by the leading projects will have a very large pulling effect on the entire sector. The following figure shows the impact on the centralized exchange before and after the issuance of the derivatives leader dYdX and the spot leader Uniswap. It can be seen that after the issuance of UNI, spot Dex / Cex Ratio jumped to 20% and it is never getting back to the level before August 2020 (rumors of token launch came out after the last round of fundraising).

Data Source: The Block. Note: I ignore the Sept figure for incomplete data.

Dive in, who are the best ones?

I here only discuss: Perpetuals with linear P&L, Options with convex P&L, and Synthetics with irregular P&L.

Perpetuals with US$47B accumulated volume proved themselves are most welcomed, 92 times the figure of Options. The latter one is suitable and attractive for professionals to hedge. However, there are several projects that are trying to bring it mainstream. Shield Official is testing simple perpetual/everlasting option products for general users.

Synthetics are interesting. But sadly, they are all not as easy as perpetuals to understand and trade, while some of them provide diversified innovative yielding products. For example, one of the most popular products on UMA is Yield Dollar with ~US$36M assets locked, which is similar to a zero-coupon bond (fixed interest rate/yield).

“Peer to Pool” or “Peer to Peer” ?

  • “Peer to Pool” means the traders’ counterparties are pools, or the stakers, normally. For example, if you are staking PERP on Perpetual Protocol V1, you are actually the counterparty of those traders. You are taking this risk because you are rewarded to do so (rewards come from trading fees and inflation). They even create a Virtual AMM to cut out price fluctuation for stakers to decrease impermanent loss. The purpose is to make stakers stake to expand liquidity. That’s important: imagine only one trader in this system, if he bet right, who should pay him? Now, we are clear why Perpetual Protocol can only allow you to have 10x maximum leverage, and why it sets an emergency shutdown function. Risk control is important for those derivatives platforms to prevent net negative positions.
  • “Peer to Peer” means the traders’ counterparties are other traders, or the market makers, normally. For example, dYdX has an order book, which is a sign for matchmaking. That is, different from Perpetual Protocol, ideally, dYdX has zero involvement in trading against anyone. Hence I do see dYdX has a high tolerance for 25x maximum leverage.

I believe both are needed in the near future. “Peer to Pool” shows the capacity for long-tail assets that have low liquidity. It can even allow freely list token derivatives in the future, which may be adopted in Perpetual’s Curie version. Meanwhile, “Peer to Peer” provides a similar Cex experience, such as various types of orders, compared with Perpetual Protocol V1 only has market orders. But I do see solutions from Uniswap V3’s design, which makes limit order and more order types possible.

The evolution of derivatives

I see “Peer to Pool” Perpetuals as an improved version of Synthetix. There are 3 reasons: a) why bother to use a more complex system when you can easily get crypto exposure from Perpetuals; b) currently, near 90% of synths on Synthetix are cryptos synthetic tokens, which means the need for real-world assets is not mature. Additionally, perpetuals are capable for real-world assets derivatives as well; c) Margin is well adopted and it shows higher capital efficiency than collateralization, comparing 200% liquidation ratio of Synthetix with 2.5% liquidation ratio of Perpetual Protocol.

Going to the Moon?

I analyzed the metrics of current spot dexes and initiated a useful multiple for further valuation projection: “FDV / APR” (Fully Diluted Valuation / Annual Projected Revenue).

Multiplying FDV / APR median of spot dexes by derivatives APR accordingly, I estimate FDV for dYdX would be ~US$11,451 Million, and FDV for Perpetual Protocol would be ~US$2,801 Million.

Given dYdX total supply of 1,000,000,000, per token price should be ~$11.45.

Interestingly, the estimated figure is not too far from reality: FDV of Perpetual Protocol is ~US$3,010 Million, as of Sept 1, 2021.

Data Source: The Block, CoinGecko
Data Source: The Block, CoinGecko

Appendix: 2 types of derivatives comparables

References:

(all the data captured as of August 31, 2021)

(1) Accumulative Vol:

Perpetuals US$46.8B [dYdX: US$17.5B from dYdX metabase metrics; Perpetual Protocol: US$25.1B from Dune Analytics @yenwen / Perpetual Protocol; Futureswap: US$4.2B from futureswap.com.]

Synthetics US$9.4B [Synthetix: US$9.4B from stats.synthetix.io; UMA: no transaction data, TVL is US$144M from projects.umaproject; Mirror Finance: ~US$13.9M from the most traded assets on mirror.finance;]

Options US$507M [Hegic: US$492M from hegic.co; Opyn: US$15M from Dune Analytics @loren / Opyn v2.]

(2) Our calculation is based on data from CoinGecko.

(3) https://image.tokeninsight.com/levelPdf/TI_Research_Report_-_2021_Q1_Crypto_Perpetual_Trading.pdf

(4) Our calculation includes the volume of dYdX, Perpetual Protocol, and Futureswap sourcing from CoinGecko and Dune Analytics.

(5) Our calculation includes the volume of dYdX, Perpetual Protocol, and Binance Futures, Huobi Futures, OKEx Futures, FTX derivatives, Bybit Futures. Data source from CoinGecko.

(6) I ignore the Sept figure for incomplete data. https://www.theblockcrypto.com/data/decentralized-finance/dex-non-custodial/dex-to-cex-spot-trade-volume

(7) https://projects.umaproject.org/

(8) Fundraising Amount:

Perpetuals US$97.4M [dYdX: US$87M; Perpetual Protocol: US$1.8M; Futureswap: US$1.6M; MCDEx: US$7M; from multi-sources including Crunchbase.]

Synthetics US$55.7M [Synthetix: US$46.1M; UMA: 4.6M if estimate IDO raised $2M; Duet Protocol: US$3M;]

Options US$26.1M [Hegic: ~US$12M on ICBO; Opyn: US$9.1M; Primitive: US$3M; Shield: US$2M; from multi-sources, including Crunchbase.]

(9) https://stats.synthetix.io/

Others:

https://research.paradigm.xyz/Yield.pdf

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FionaHe

Written by

FionaHe

A&T Capital

Backed by a world leading fintech giant and other institutional investors, A&T Capital is uniquely positioned to support promising decentralised digital age start-ups to realize their full disruptive potential.