Liquidity Mechanisms for Derivatives
In Part 1 of this series, we presented an introduction to synthetic derivatives. In this post, we’ll cover different mechanisms for liquidity and trading.
There are three key areas that affect liquidity when trading crypto-derivatives:
- Risk: What is the risk exposure that I get? Are there standards (ex: each BitMEX perpetual contract is $100K of bitcoin price exposure) or is it customized (ex: Song and Lubin’s famous bet)?
- Custody: Who holds onto my collateral, and how are liquidations handled?
- Trading mechanism: How do buyers and sellers identify each other to trade?
While all three are related, for purposes of today’s blog post, we will mostly focus on different types of trading mechanisms.
Central Orderbook (also known as exchanges)
The most familiar way of trading derivatives is through a futures exchange. An exchange operator defines standard terms of risk and liquidation. To manage liquidations efficiently, they typically take custody of traders’ collateral. They also maintain a central orderbook and match buyers and sellers to each other. Liquidity begets liquidity, and network effects are difficult to displace. Exchange operators can become quasi-monopolies.
Furthermore, when trading on a custodial futures exchange like BitMEX, traders effectively face the exchange as their counterparty. If the exchange disappears or does a poor job managing risk, traders lose both their synthetic exposure and their deposits.
To “decentralize” the parts of central orderbooks that are scary while attaining the liquidity network effects of central orderbooks, we can use smart contracts to separate these three areas of risk, custody, and trading from each other. For example, an UMA smart contract can specify the standard unit of risk and hold onto trader collateral. However, buyers and sellers can still identify each other through a central orderbook.
Distributed (also known as peer-to-peer, or P2P)
In peer-to-peer trades, buyers and sellers interface directly to negotiate the trade. Gentlemen’s agreements like the Jimmy Song-Joe Lubin bet are one way to agree to terms. However, they carry the risk that someone won’t pay up. Smart contracts could be a way to lock collateral to ensure that Jimmy won’t weasel out of payment. However, these P2P trades tend to be both infrequent and highly customized, making it difficult to transfer risk and grow liquidity.
Decentralized Orderbooks (also known as over-the-counter, or OTC)
OTC trading can be the best of both worlds. Similar to P2P trading, buyers and sellers interface directly, enabling them to customize terms. Unlike P2P, however, professional market-makers aggregate the net buy and sell risk across many individual positions, and also connect multiple liquidity pools (including traditional futures and spot markets) together. This allows them to provide the benefits of P2P customization whilst fostering liquidity in the marketplace overall.
The OTC market-maker is a master of risk management. Whenever she does a derivative trade with a customer, she makes an adjustment to her portfolio to keep it balanced so that she is left with very little net exposure to the price of the underlying asset.
The vast majority of fiat derivatives are traded through this OTC mechanism. Despite a fairly small number of major market makers, liquidity in OTC derivatives is similar to futures for most products. It’s also quite profitable: Goldman Sachs alone generated over $1B last quarter doing this juggling act — and it was their worst year for market making profit in a decade.
Contact us if you’re interested in learning more about OTC trading, and how you can use UMA contracts to facilitate risk transfer.
Regardless of how these derivatives are traded, all of them require a pricing oracle to settle payouts. If you can control the oracle, it doesn’t matter that your counterparty’s collateral is in a “decentralized” smart contract: you can still steal their assets. Historically, some oligopolistic fiat OTC market-makers have slyly exercised their power by manipulating the way that their derivatives are valued.¹,² We believe that we can use the power of blockchain oracles to attain network effects without these market power costs.
In our next post, we’ll talk about the importance of economic guarantees in blockchain oracles, and our proposed solution: the UMA Data Verification Mechanism (DVM).
