From Commodity Speculation to Financial Speculation: the Symbol Game of NFT Derivatives
NFT Speculation Thesis
It’s well recognized that the business operations of speculative traders are irregular and uncertain. Perhaps he is a stock trader this year, and next year he may become a crypto trader and next year after that he may shift to be a NFT trader.
Whatever the trade, he enters it as long as he expects that the returns in it are likely to be higher than in other trades, and he exits when the returns fall below other trades (Admin Smith, The Wealth of Nations).
NFT Financial Derivatives have the potential to expedite the transformation from commodity speculation to financial speculation, resulting in tremendous potential ROI.
FT > Financial Speculation: It requires a more developed financial market as a foundation, often driven by the process of speculation. The price volatility is high and the price is less sticky.
NFT > Commodity Speculation: It is difficult to create some form of financial market in the short term, and ordinary commodities or capital goods may become the underlying. Price volatility is generally not as high as financial markets and price is more sticky.
Based on my understanding, it is impossible to build a sound financial speculation market on top of an immature underlying asset market. Therefore, I do not think that NFT derivatives will take off shortly. However, once the NFT market matures, the derivative layer will certainly experience exponential growth in the future.
Though huge traction won’t be obesrved in a short term based on the analysis above, legit demand for trading NFT derivatives obviously exist.
We can simply divide it into four categories:
1/Speculation: People want to make money by betting bluechip NFTs yet have limited capital & face high transaction fees\royalties to directly flip NFTs in the spot market. (long demand)
2/Yield enhancement: People want to make more money by adding leverage. (long demand)
3/Hedging: People want to hedge risks of holding NFTs. (short demand)
4/Portfolio Diversification: People want to diversify portfolio risks to new asset classes (long & short demand)
Furthermore, NFT derivatives also have a strong upward trend in the foreseeable future.
FT derivatives market trade volume is about 3x of the spot. Assuming similar dynamics, the short-term best case scenario of NFT derivatives can be at least 3x of spot bluechip NFT volume (Est. $8B). Even if the NFT derivatives market wouldn’t be as large as FT’s, the growing momentum can be expected.
With the same two characteristics of illiquidity and hard-to-value, the financial evoluation of property is also well suited to be used as a benchmark for NFT development. Benchmarking real estate derivatives (property derivatives): Derivatives on real estate related debt, such as Mortgage Backed Securities (MBS) and Credit Default Swaps (CDS) represent a large market, est. Notional value will be over $10 Trillion.
In the following sections, a detailed analysis of the NFT futures and options verticals will be unfolded respectively.
Futures (Perps)
Similar to FT futures trading, NFT futures trading can be a lucrative business. NFTperp managed to earn an impressive trading fee from their beta master network within 3 months. OpenSea’s profitability comes from its high fees (2.5%), despite having a smaller trading volume than Uniswap. If NFT’s perpetual trading market becomes popular among high-frequency and prop traders, then even if the trading volume cannot match that of FT perpetual trading, the future fee drawdown will be enough to generate a good profit return.
Trader’s feedback
To further identify the value and potential user market for the existence of NFT perpetual trading, we captured the following feedback after conducting interviews with dozens of traders:
- Mechanism matters: should be a fair game (most important)
- Incentivization & leverage matters: will join for huge returns
- Don’t care much about the manipulation in spot market
- No loyalty to the platform. First mover doesn’t matter to them.
- Small premium features like social messaging will improve attractiveness
Project Comparison
Case study: NFTperp vs Tribe3
A. Similarity
Both NFTperp & Tribe3 adopted the vAMM design:
- No need real LP, no need order book
- Traders are the counterparty, one trader’s gain is another trader’s loss.
- Both sides of traders will take slippage to open positions (usually 0.5% tolerance).
- By adjusting the k-value, the depth of virtual pools can be dynamically adjusted so as to avoid extreme price fluctuations caused by excessive slippage (The larger the value of K is, the lower the slip point will be).
- All profits and losses are both settled in the insurance fund.osses are both settled in the insurance fund.and losses are both settled in the insurance fund.
A simple analysis of the pros and cons of the three mechanisms — Orderbook, AMM, vAMM — can be found in the following figure:
B. Differences
The main differences between NFTperp and Tribe3 are reflected in the design details of the vAMM mechanism, black swan scenario handling, oracle feeding price and updates (see the figure below). However, it remains difficult to determine which one can find PMF in first place, as success may be highly dependent on whale acquisition capacity and ecosystem development.
Potential Risks
Adoption risks
The spec spectrum is limited despite the leverage chances. It’s true that the derivative market lowers the speculation barrier but the mindset is still to treat NFT as FT and I doubt the necessity to create a market that is infinitely similar to token derivative market even considering certain risk diversification demand existing.
And there’s no fundamentals (FT mostly owns some basic fundamentals, excluding meme coins) to help traders analyze the strategy. In the NFT scenario, we can only depend on the community moves/sentiments and purely technical analysis to help make a decision, thus pro traders in tradfin area without altcoin trading experience may fear getting burned in the game (best scenario will be 1–2 prop desk traders handing on this business with at most $50M risk position).
Yet most NFTs are still can be traded as altcoins so from that perspective derivatives on the floor price would make sense. If one day NFT can acquire more value, we can analogize the real estate market. It might still be interesting for people to speculate on the floor price of New York real estate. But mass adoption definitely cannot be realized in the short term so the thesis will be mostly on the profitability side.
Oracle risks
The biggest tech risk shall be the oracle attack and different kinds of oracle manipulations like MEV bots/front-running arbitrage. The oracle mechanism is very crucial in the whole perpetual exchange building and I do think most NFT oracle mechanisms are flawed and partly centralized. They are not getting attacked just cuz they haven’t reached a high volume compared with FT perpetual exchanges (limited arbitrage yields) . The solutions from my mind should be:
- Integrated multi-oracles to avoid single node failure like perpetual protocol. Manipulation risks can be reduced when different oracle reporters send deterministic data to the blockchain using different data processing mechanisms.
- Source price input from multiple data providers. The calculation of one NFT collection’s determined pricing can be cross-checked by sales data collected by Dune Analytics, Reservoir, the OpenSea API, or a custom subgraph monitoring OpenSea’s smart contract events.
But according to my conversations with traders, they actually don’t care much about the manipulation in the spot market. And we have the consensus that the cost of attack would be very large and it wouldn’t be possible unless the derivatives market is 10x larger than the spot market (which is unlikely). Thus filtering only the collections that have a lower likelihood of manipulation would be extremely important. As long as the filtering system makes sense (the same thesis of nft lending), the inherent manipulation risks are not likely to prevent people from speculating.
Options
FT vs NFT
The prices of each NFT are different over time, just as investors in stock/FT futures will see the prices vary from month to month. And similar to the upstream trade in commodities, NFT has a higher purchase threshold, larger price step and poorer liquidity. Thus retail traders/collectors cannot buy and sell NFTs as they go by immediately receiving one bid/spot price for one NFT as they usually would for FTs/altcoins.
As a result, NFT traders have a natural need for more flexible and varied contracts and trading methods. When the liquidity situation is favorable at the moment and they have sufficient funds, traders can choose to purchase spot directly, while when they are in a shortage of capital or have low confidence in the current market, traders can sign contracts for forward delivery to better arbitrage and hedge risks.
For example, NFT traders can now simultaneously enter into spot contracts to exercise in a few days, forward contracts to exercise in 1 month, forward contracts to exercise in 3 months, and the strike prices of these contracts are generally varied due to different expected market supply and demand conditions.
NFT Futures vs Options vs Forwards
Futures contracts actually represent those standardized (securitized) forward contracts transferred for sale and purchase on a public exchange (OTC >> Floor). In traditional commodity trading, spot contracts are traded in decreasing volumes, instead, forward contracts & futures contracts are increasingly traded.
The differentiation between option contract and futures contract is the buyer of option contract has the right to refuse contract execution if the price falls and the buyer will be charged a premium fee for this right.
Assuming the option fee for a BAYC option position executed three months later is 3eth/BAYC, the buyer needs to compare the maturity buy spot price with the current contract price to decide whether to sign it or not. For example, if the current spot price is 50eth/BAYC, it’s only beneficial to sign the contract when the maturity spot price rises above 53eth/BAYC. And for comparison, futures contracts can be cost-effective as long as the maturity spot price is higher than 50eth.
However, if the spot price of BAYC falls below 47eth after three months, the option contract is better than futures because you can refuse to execute the contract and buy the spot directly at that time, in which case the money you saved by buying the spot is more than the option fee you paid. The buyer of an option contract can also transfer the contract to another person at another price, that means option positions/contracts can be used or aggregated into financial instruments such as ETFs or developed into more complex metamarkets (release more imagination for NFT structured products).
Project Comparison
Potential Risks
Mainly about adoption risks. Need to educate lay users. In the early stages, traction is likely to be driven by MMs and professional traders.
One more thing
In the end, I’d love to chat a bit about financial philosophy.
As early as 20 years ago, internet companies began exploring the commercialization of virtual goods. The next generation of O2O, instead of online to offline, should be onchain to offchain. NFTs in art and gaming are just a small demonstration of this non-standard protocol on the blockchain. As more and more off-chain assets are written into the blockchain in the form of NFTs, we may see a new business and financial paradigm based on NFTs in the next cycle.
Ultimately, the reason why gold is valuable is because people perceive it to be valuable. The US dollar itself is just a symbol of a symbol. The collapse of the gold standard made value a fluctuating signal, and virtual capital does not have to follow the same value principles as the real economy. Market fluctuations are largely determined by the beliefs of symbol holders and their subjective expectations for the future. The abstraction of the trading actions is caused by the symbolization of underlying assets.
Therefore, whether the underlying asset represented by this symbol is fiat currency, securities, tokens, or meaningless small pictures, is no longer important. They, like history, are not real, but rather are chosen to be believed in.
A bold prediction is that what will eventually circulate widely in the market will no longer be value, but purely symbols, meaning, or let’s say “beliefs”. In the interweaving of hedge, speculation, and ponzi, everything will continue to cycle back and forth as the Minsky cycle.
It‘s just money, it’s made up :)
