MARKETS INSIGHT — DIFFERENT DERIVATIVES PRICING MODEL IN DEFI
DeFi derivatives, mainly perpetual contracts, have surged in users recently. This article examines different pricing models
Originally written on MetalSwap’s Official Blog — Markets Insight: Different Derivatives Pricing Models in DeFi
The derivatives sector in DeFi has evolved rapidly in recent months, with the number of users utilizing these instruments growing exponentially.
As we all know, the most commonly used type of derivatives within DeFi is perpetual contracts. Therefore, in today’s article, where we analyze the different derivatives models available in DeFi, we will mainly refer to this specific sector.
The pricing model is the core of a derivatives protocol, and there are various models, each with its pros and cons.
Today’s deep dive does not aim to find the best one but to simply identify and explain the different options currently available.
Three different pricing models
In DeFi, there are primarily three pricing models and, therefore, types of derivatives we can find.
By pricing model, we simply mean the mechanism by which the derivative instrument is valued and traded.
Derivatives, by their very nature, are products that do not have intrinsic value but refer to the underlying products they replicate. Currently, within decentralized finance, the most widespread pricing models are Oracle-based, Hybrid, and Virtual AMM (vAMM).
Each of these has its pros and cons, and now we will analyze them one by one to uncover all their secrets.
Oracle based
This is probably the most widespread model in DeFi. In this case, the price of the underlying asset is determined by the value that a series of decentralized oracles transmit.
Let’s go straight to a practical example to understand this mechanism.
In a perpetual DEX using the oracle-based model, the price of BTC, for example, is not internal to the dApp but is taken from what various oracles, such as those from Chainlink, continuously transmit.
This is a price that comes from outside and where the trades on that specific DEX cannot influence it.
This mechanism is widely used as it is relatively simple to implement and quite scalable. To add a new asset to the dApp offering derivatives, it just needs to have the oracle of that particular asset, which can be both native crypto and external to this sector, such as gold within the MetalSwap dApp.
One of the major cons is certainly related to the security of these oracles, as there can be price manipulations, causing significant problems for the dApp.
To avoid this problem, the oracles need to be structured in a truly decentralized system with appropriate security measures implemented.
Hybrid model
The hybrid system takes the best from both worlds, the decentralized and the centralized.
All hybrid models, especially in the perpetual sector, offer speed and a user experience very similar to centralized CEXs, as they also offer an order book.
The order book, or also called “sequencer” is the key element, and given its extremely complex nature, it is impossible to create it on-chain.
Hybrid systems, therefore, have an off-chain order book while managing user funds and approving transactions on-chain.
This mix is undoubtedly the most effective and efficient but comes with many risks related to the not fully decentralized nature of the project.
There are also regulatory risks since a system relying on a centralized order book is much more vulnerable compared to a 100% on-chain project.
Virtual AMM
Finally, the Virtual AMM (vAMM) system is the third model and perhaps the most complex currently available.
This pricing system, introduced by Perpetual Protocol, simulates a classic AMM like Uniswap, using it as a pricing system but utilizing virtual assets.
Users of a virtual AMM deposit collateral within a clearing house, which is the only entity that can interact with the virtual token pools.
Being virtual tokens, the clearing house can also mint “extra” tokens, making it possible to create trades with leverage.
In this model, liquidity providers, just like in regular AMMs, can deposit liquidity into the pairs and earn from the trading fees paid by traders.
This system is undoubtedly the safest and most decentralized but also the slowest and costliest for traders.
Due to its 100% on-chain nature, the execution speed cannot match that of hybrid models based on order books. However, as mentioned earlier, this model ensures greater security as there are no centralization points.
Conclusion
In summary, the rapid evolution of the DeFi derivatives sector has led to the development of various pricing models, each with unique characteristics and trade-offs.
The Oracle-based model offers simplicity and scalability but relies heavily on the security of decentralized oracles.
The Hybrid model combines the advantages of decentralized and centralized systems, providing speed and efficiency at the cost of regulatory and centralization risks.
The Virtual AMM model, while being the most secure and fully decentralized, faces challenges in terms of execution speed and higher costs.
- The DeFi Foundation
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With Hedging Contract we enable hedge swap transactions through the use of Smart Contracts, AMM style.
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