Why will derivative DEXes hype across different chains?
Trends in crypto come and go away. DEXes, individual blockchains, P2E games, Decentralized option vaults or Yield optimizers — different sectors outperformed the market at particular times, so when is the derivatives DEXes’ turn?
To provide you with a more in-depth understanding of the topic, we will first observe what derivatives are in a nutshell, then we’ll overview current trends in DeFi, and we’ll finish the article with the advantages of decentralized exchanges that offer derivatives trading. Let’s go!
What are derivatives?
Derivatives are financial contracts, whose value depends on an underlying asset or groups of assets.
For example, let’s take a look at BTC perpetual on Deribit. It has prices, and orders in the order book, but if you buy it you don’t buy real Bitcoin. Instead, it’s only your bet for the future price moving against other people’s bets, but the price of the derivative is bound to the real Bitcoin price with the funding rate. So, in general, you trade not real Bitcoin, but a derivative with a similar price.
Why do people do that? Why do people trade weird substitutes instead of normal Bitcoin? There are some advantages of it:
- Capital efficiency. In case of opening a position for any direction, you don’t have to have a lot of money. For example, for buying 1 BTC-Perp users might need only ~$2000 as collateral, in comparison with $47000 for spot BTC. But be careful, in case of price movement against your bet your position will be liquidated (leverage multiplies not only gains but also losses, alas).
- Low fees. Spot trading is more expensive than futures. For example, on the Binance spot market the regular user fee rate for maker and taker is 0,1%, and on the USD-M section is 0,02%/0,04%. That’s much cheaper!
- Possibility of selling short cheaply and simply. You just choose to trade short, not long, whereas in the spot section selling short is more difficult and expensive — users have to put some collateral, borrow assets and finally sell them. Typically, derivatives are used for speculating and hedging, whereas spot trading is better for long-term investments, because you don’t have to pay for funding or roll your futures in case they have an expiration date.
Ok, now you understand derivatives. After empowering our knowledge let’s move on even further!
DeFi & CeFi trends: Derivatives
Some trends have only a temporary impact, while others stick for a longer time. Let’s find out what happens with derivatives on traditional markets and in the crypto environment.
Derivatives vs Spot in TradFi
According to a Businessinsider article from 27 of May 2020 the total value of stock markets was $89,5 Trillion. This number includes all markets around the world.
At the same time, the capitalization of derivatives looks like…well, much bigger than the spot market.
- Spot market capitalization — $89,5 Trillion.
- Derivatives market notional value — from 558.5 Trillion to 1 Quadrillion, depending on estimates.
So, derivatives are bigger than the spot by 6.24 – 11.17 times!
Centralized Derivatives vs Spot exchanges
Unfortunately, nobody counted notional value in crypto, but we can estimate the trends with volume!
According to CryptoCompare, the monthly derivatives volume is $2.6 Trillion, whilst the Spot is “only” 1.6 Trillion. As we can see, spot volumes were high back in 2020, but now derivatives volumes dominate, and their share becomes bigger.
The bottom line is, that the derivatives volume became bigger than the spot, and this trend has been going on for a long time! But what about DeFi?
As may be noted, funds are slowly moving from CEXes to DEXes. And this trend probably will increase because the current banned and frozen accounts cases demonstrate that people lack control over the money they store on centralized exchanges. More and more people move their funds to DEXes, sticking to the principles of censorship-resistance, more explicitly.
Derivatives DEXes vs Spot DEXes
Let’s compare the trading volume of two types of DEXes. Unfortunately, there is no such information in public articles, so we figured it out ourselves.
Derivatives DEX to spot DEX trading volumes in per cent are not so small, or 36%, however, as shown in the chart below, main volumes come from only one exchange — dYdX, which is responsible for more than 75% of derivatives DEX volume.
Hence, derivatives are still far away from dominating in decentralized crypto, yet there is still a lot of space to expand, and we expect that this will happen, especially considering the development and adoption of fast and scalable blockchains and Layers 2 — and that is the main point of next part of our research.
The first attempts to build an on-chain order book DEX took place on Ethereum back in 2017, but such exchanges didn’t become popular due to low transaction speed and high gas prices. If you remember the experience of using IDEX at that time, you understand what we mean.
For efficient order book trading, it’s necessary to have a very fast and cheap blockchain, and that’s where all EVM chains face challenges, they are still too slow and expensive.
Many things have changed since AMM’s invention, algorithmic price definition literally changed the rules, and many exchanges, such as Uniswap, Sushiswap, Pancakeswap, etc. have come into sight. But does AMM fit for fast derivatives trading? It’s a question for individual research, some protocols try to do derivative AMM DEXes, and we might see if it works or not, only in the future.
With the emergence of Layers 2 (Arbitrum, Optimism, Starkware) and fast blockchains such as Solana and NEAR Protocol, many teams rushed to build derivatives DEXes. It’s important to note that this task is completely different from the usual spot swap. Several important parts of the protocol, such as liquidation mechanism, matching engine, oracle system, collateral, etc. should work properly and fast. In case of a mistake or delay, losses might be huge and the user’s experience is spoiled.
The diagram below shows a comparison of different Layer 1 blockchains’ speeds.
Most blockchains are not suitable for on-chain order books, as their speed is too low. Even Layers 2 might be slow, for example, dYdX uses an off-chain order book, because Starkware velocity is not good enough. However, Solana and NEAR Protocol are fast enough, and they can provide a close to CEX experience for users.
So, with the development of blockchains, opportunities for DeFi become better. Comprehensive protocols, which require high speed and cheap transactions may start capturing users and move them away from slow blockchains, and typical disadvantages of DEXes might disappear.
Other advantages of derivatives DEXs
A truly hardcore DEX might be used by anybody from anywhere. KYC, restrictions for countries or other types of censorship just can’t exist in a decentralized world. A nice case here to demonstrate the level of permissionless access is Uniswap, which blacklisted more than 100 tokens from its interface, but any person still can use another frontend for getting access to the protocol and trade anything they want.
If funds are not stored in your account, you are not the real owner of funds. Any centralized exchange bears a counterparty risk of dishonest owners, security vulnerabilities, and threats from the government. Even if nothing bad happened with your deposit in the last few years, can you be sure that the same will happen in the next 10 or 100 years? A good example here is the USA’s Executive Order 6102. Are you sure anything like that will never repeat again in any country across the world? The truth is — no one is. The safest way of keeping any assets is keeping them in your own blockchain wallet if no other person has access to it.
TradFi exchanges usually work in particular hours during weekdays. And if you want to make some operations on weekends or holidays, especially in case something important happens, you can’t do it. But the worst case is a long blackout. For example, Moscow Exchange was on vacation from 28th February till 24th March due to the recent geopolitical events. Additionally, trading opened with only 33 stocks, not the entire market. Can you imagine Uniswap not being operational for an entire month, and freezing your assets for an undetermined time?
Trade anything, from anywhere
The most undervalued case about DEX derivatives is that you can actually trade anything, from anywhere. If CEXes have some regulatory limitations, for example, FTX users from several countries can’t trade tokenized stocks, in the DeFi anybody can trade anything which opens opportunities for new markets.
For opening a new market you just need a market-maker who will provide liquidity and secure oracle price feed for pricing! A good case here is the recent fast listing APE-Perp by Drift and 01.xyz. People have a demand for this token and they get the possibility to trade it. It’s not only about crypto assets, if traders want to trade assets from TradFi, such as oil, gold, US treasuries or any other asset as perpetual, why shouldn’t they? And again, the question is only about oracles and market-makers.
An acute problem for decentralized exchanges is the lack of institutional traders. It’s not easy to lure them, especially on some new platforms, but they definitely will come after some time, because new exchanges give many opportunities for making a profit.
And last, but not least advantage of DEXes is its composability with other protocols. An example case that will be implemented on NEAR protocol by some platform with a 100% probability is multi collateral. Users take their NEAR, stake it to stNEAR, and use this stNEAR as collateral for trading without selling it to USDC. Moreover, stNEAR, as a Yield-Bearing token generates yield and if the user doesn’t use tokens as collateral stNEAR brings additional earnings as it gets directed to other platform users! In this way, users’ capital efficiency increases a lot.
Another case is the possibility to connect a derivatives DEX with a decentralized asset management platform, where people can provide capital to professional managers or traders, who will further generate better returns for both sides.
There are many possibilities for using DeFi lego in derivatives, and there will be more of them shortly, so keep abreast!
As you can see, we’re very inspired by the derivatives DEXes future. So many possibilities are open now, and so many will be revealed, but now let’s review the main statements from the article:
- Current trends convince us that the trading volume will flow from CEXes to DEXes, and from spot protocols to derivatives.
- With improving blockchain technologies, issues regarding speed and cost of transactions move away. Fast Layer 1 or Layer 2 blockchains will break barriers for dApps that existed before.
- CEXes will lose their advantages compared to DEXes. But CEXes will never get advantages of DEXes, such as non-custodian essence, permissionless nature, censorship resistance and composability.
- Institutional traders will bring volumes and money to DEXes, it’s just a matter of time.
- DeFi lego will connect (actually it already connects!) many different dApps together, so the user will be able to use capital efficiently and enjoy many use cases for his capital, such as trading, asset management, options, farming and many others!
Eventually, we’d like to say that we live in a great time of crypto technology adoption. Today, any person can be not just spectacular, but an ecosystem participant. The Internet unlocks the possibility to explore, use or develop anything related to crypto. Decentralized derivatives are not the only part of DeFi and crypto, but definitely have a great potential to grow in 2, 5, 10 times or more, and the Spin team will research, build and share our success with you!