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The Dawn of Decentralized Derivatives

Mar 29, 2021 · 27 min read

By Ashwath Balakrishnan

An Introduction to Futures and Perpetual Swaps

 

In the past year, we’ve seen an influx of new market participants to crypto, including large financial institutions and respected investment funds. This wasn’t an overnight process — it started happening over the course of the last bear market and has continued into the current bull market. While this was brewing on the sidelines, crypto exchanges were building the necessary infrastructure and products to cater to this growing audience.

The biggest difference between the market today and during the last cycle is the proliferation of derivatives — notably, perpetual swaps. Perpetual swaps are derivatives that let you buy or sell the underlying asset at any point in time. They’re basically futures contracts with no explicit expiration date. And because of that, they’re usually bunched in with futures. Perpetual swaps are also called perpetual futures.

Perpetual swaps rely on two critical aspects to be useful: an index price and a funding rate. In order to ensure a perpetual contract is trading at its fair value, it needs to anchor itself to an index price. This index usually comprises BTC-USD price feeds from multiple spot exchanges such as Bitstamp, Bitfinex, Coinbase, and others. But for the perpetual contract to trade in line with the market, there needs to be an incentive for arbitrageurs to restore price parity. That’s where the funding rate kicks in.

When a trader goes long or short using a perpetual swap, they have to pay a small percentage in funding fees on a periodic basis depending on the ratio of longs to shorts. Depending on whether the price of the perpetual is above or below the index price, exchanges use funding to create incentives to converge market price and the index price.

If a BTC-USD perp is trading at $56,000, and its index is trading at $55,000, the funding rate is positive for longs (they pay fees) and negative for shorts (they receive fees). This creates an incentive for traders to short the perp and earn funding. If enough people act on this incentive, the perp’s price falls to meet the index price. This particular strategy is called a “basis trade.” Traders who do this offset their exposure to the perp by doing the opposite action in the spot market. In the example above, a trader could short $10,000 of BTC-USD perps at a price of $56k, buy $10,000 of BTC spot at a price of $55k, offsetting their exposure while collecting the funding fees.

Given the simplicity and utility of perps, it has become the instrument of choice for most traders.

The State of Crypto Perpetuals

 

In Jan. 2020, BTC futures registered monthly volumes of $427 billion as open interest ranged between $2.6 – $4 billion. Compare that to Jan. 2021, when Bitcoin futures volume hit $2.2 trillion and open interest eclipsed $20 billion. As serious money flows into the industry, it’s impossible to ignore the derivatives market. Options open interest and volume also surged during the course of the last year, further pointing to growing derivatives adoption.

Perpetual products already have obvious product market fit. According to CoinGecko, roughly 85% of daily BTC futures volume comes from perps. But given Bitcoin’s dominance amongst the institutional crowd, many believe it’s the only important asset to track futures flow for. The data for ETH futures and perps, however, begs to differ.

While perpetual swaps make up the bulk of crypto futures volume, there are standard futures on exchanges like BitMEX and FTX amongst others. Furthermore, there has been growth in regulated CME Bitcoin Futures volume, which confirms the uptick in institutional interest.

From Jan. 2020 to Jan. 2021, ETH futures volume grew from $41 billion to $764 billion — an 18x increase. Currently the focus is on BTC and ETH as the stalwarts of crypto, but perpetual contracts for other crypto assets routinely account for billions of dollars in daily volumes.

As adoption continues to increase, demand for speculation and hedging instruments will increase as well, boosting perp volume. That said, even if the crypto market stays at the same level it’s at today, the Total Addressable Market (TAM) for DeFi derivatives is still massive. Growth in non-BTC and ETH perps has been exponential over the course of the last year, growing from less than $100 billion of volume in Apr. 2020 to over a trillion dollars of volume in Jan. and Feb. 2021

Centralized crypto spot markets are already being being disrupted by decentralized challengers like Uniswap. The same cannot be said of derivatives yet, as DeFi volumes are orders of magnitude lower than CEX derivatives. We expect this to change soon, as 2021 potentially marks the beginning of efficient and scalable decentralized derivatives.

Decentralized Perpetuals and Futures Protocols

 

Decentralized derivatives is one of the hottest narratives in DeFi at the moment. But when it comes to actual usage, Ethereum’s scaling woes and exorbitant cost-of-doing-business have muted on-chain derivatives trading.

However, the emergence of scalable, high-throughput blockchains like Solana, as well as layer two scaling solutions such as Optimistic and ZK-Rollups promise to be the catalyst that make decentralized derivatives work. In this report, we’ll highlight existing perps/futures protocols with traction as well as a few solutions that show promise and offer some differentiation.

dYdX

While the race to build permissionless derivative infrastructure has started to heat up in the past few months, dYdX has been working towards that mission since 2019. dYdX is a decentralized derivatives exchange for perpetual swaps and margin trading. The exchange uses a traditional orderbook-based design to facilitate liquidity. Currently, dYdX’s margin trading product is responsible for most of the exchange’s volume and liquidity in its margin lending pools continues to increase. It’s worth noting dYdX’s money markets can also facilitate flash loans, providing lenders with an additional source of yield.

In the coming weeks, dYdX will publicly launch their layer 2 solution powered by StarkWare’s ZK-Rollup. This will come with several important benefits. To start, traders will no longer have to pay gas fees. Instant trade settlement and cross-margining of collateral are other major upgrades, to name a few. Most importantly, based on the security assumptions of StarkWare’s solution, dYdX maintains a secure, trustless and instant settlement system rooted to Ethereum. However, the matching engine and orderbook will remain off-chain on a centralized cloud, creating a potential single point of failure. While this means orders are matched via a centralized component, submitting an order still requires the trader to sign the transaction in the first place. When coupled with instant settlement, ensuring that account balances / PnL are accurate, risk is greatly minimized and trading remains non-custodial.

In terms of current usage, the exchange has come a long way since it launched v2 in mid 2019. Between Jan and July 2020, dYdX facilitated daily volumes of $300k-$2.5 million. Since December 2020, the exchange has been routinely executing $20-$40 million of volume per day. While they may not seem like blockbuster numbers, let’s remember that this growth came during Ethereum’s most congested period in history.

Additionally, this data doesn’t reflect liquidity on dYdX’s orderbooks. A quick look at the interface shows you just how liquid the exchange’s books are — especially for ETH base pairs. With the cost of using the protocol set to dramatically decrease with the new L2 solution, it’s reasonable to expect dYdX’s growth trajectory will remain stable at the very least.

Finally, while the project hasn’t publicly revealed any intention to release a token, dYdX is still a profitable exchange. dYdX has earned $3.71 million in fees over the last month, and $15.56 million since launching v2 in 2019. According to TokenTerminal, 88% of dYdX’s fees are protocol revenue while the remaining 12% are rebates paid to market makers. If dYdX were to launch a token, there is already a healthy fee base to fund governance incentives. With the addition of new markets and L2, dYdX’s can be expected to multiply its fee generation as volumes rise.

An important thing to consider with dYdX is that it’s orderbook and trade matching engine have worked in production for almost two years now. No other derivatives DEX can say that.

As the first scalable and non-custodial derivatives exchange, we expect the launch of dYdX’s L2 to be a major catalyst for the project, pushing volumes and user numbers higher.

Perpetual Protocol

dYdX uses an orderbook, as do all centralized exchanges. Perpetual Protocol, on the other hand, uses an AMM like Uniswap’s to facilitate trading of perpetual swaps in a fully on-chain manner.

Perpetual Protocol actually integrates Uniswap’s price curve — the XYK function — for it’s own AMM, but it does so with a twist. Without the twist, Perpetual Protocol would just be a Uniswap for perps. That would require liquidity providers to come in and bootstrap the pools, taking on the risk of impermanent loss in the process.

But none of this is necessary on Perpetual Protocol. The project use a novel virtual AMM (vAMM) that simulates price changes for the underlying asset of a perp. A user deposits collateral into Perpetual Protocol and use that collateral as margin to trade perps. When they enter a long or short position, they mint vTokens which can be used to trade with the AMM. vTokens are synthetic assets representing a claim on real assets. For example, using 100 USDC of collateral to go 5x long on ETH would give the traders 500 vUSDC to buy vETH with. The vAMM swaps the 500 vUSDC for ETH at the vAMM price, giving the trader exposure to roughly $500 of ETH via a perpetual swap.

All positions are collateralized; profits and losses are realized upon settlement, and the protocol should* always remain solvent. Further, each pool’s liquidity depth is a virtual configuration. Liquidity parameters (i.e. the amount of tokens X and Y in the pool) are decided in a way that guarantees deep liquidity. But liquidity also shouldn’t be too deep so as to allow funding arbitrageurs to re-balance the vAMM price without a significant sum of capital. As more arbitrageurs and traders pour in, the vAMM for each market can be changed to reflect this, thus improving liquidity.

Perpetual Protocol’s growth since launch has been exceptional. Since launching mainnet in late Dec. 2020, Perpetual Protocol has facilitated $3.6 billion in perp trading volume. The exchange was averaging roughly $50 million in daily volume between January and March 2021. Since then, DEX volumes have taken a hit across the board, but Perpetual Protocol has still averaged over $30 million in daily volume in the second half of March.

In a bid to avoid all of the congestion on Ethereum, Perpetual Protocol launched on the xDAI sidechain. While this is a good short-term solution, sidechains don’t have the same level of decentralization and security as a L2 rollup on Ethereum. However, the protocol’s documentation indicates their long-term plan is to eventually roll out an a layer 2 solution like Arbitrum.

Perpetual Protocol has a native token, PERP, which accrues value from the protocol via fee capture and governance rights. The DEX has been averaging $340k in weekly fees since Feb 2021, with the bulk of that coming from ETH-USDC and BTC-USDC perps. At $340k in weekly fees, that works out to $17.7 million in annualized fees.

At the moment, all of these accrue to the DEX’s insurance fund. Once PERP staking is live, a portion of those fees will be diverted to the PERP staking pool. The PERP token’s distribution schedule is as follows: 55% for ecosystem development and liquidity mining; 15% to strategic investors; 4.2% to seed investors; 21% to the team and their advisors; and 5% in a public sale via Balancer LBP. Users and the community will own roughly 60% of PERP’s fully diluted supply.

MCDEX

In April 2020, the team behind MCDEX announced the second version of their perpetual swaps product using an XYK AMM (similar to Perpetual Protocol). This iteration of the product also used an off-chain orderbook that plugged into the AMM, giving users the ability to trade with limit orders. Within the first few weeks of launching, the protocol garnered over $20 million in TVL and $5 million in weekly volume. However, the team soon realized that a regular XYK AMM isn’t the most capital efficient way to trade perps.

MCDEX v2 entered global settlement (all open position are closed) in Feb. 2021. This was done in anticipation of the latest iteration of the DEX. MCDEX’s latest deployment protocol — Mai Protocol v3 — will be launched on Binance Smart Chain and Arbitrum’s layer two.

MCDEX v3 is a complete overhaul of v2. The DEX now uses a Proactive Market Maker (PMM) that concentrates liquidity (similar idea to UniswapV3) for perps around the current market price. LPs deposit the quote asset for a perp (USDC for a BTC-USDC perp) into a pool and perpetual swaps can be issued using this liquidity. Each pool is now a counterparty to every trader, irrespective of whether they’re long or short. As a result, LPs on MCDEX are less like actual LPs, and more like guarantors of positions taken in the pool.

Pricing is dependent on a number of factors, but the most important is the ratio between longs and shorts. MCDEX’s pricing for a particular market is at equilibrium when the ratio of longs to shorts is 50:50. This means the AMMs total exposure is delta neutral and not exposed to price risk. As the skew between longs and shorts changes, pricing becomes unfavorable for one side of the trade while becoming lucrative for the other side.

For example, let’s assume MCDEX long-to-short ratio is 70:30. The BTC-USDC index is at $55,500 but the price of BTC-USDC on MCDEX is $56,300. Pricing becomes unfavorable for anyone who wants to go long, as MCDEX’s price is higher than the index. For shorts, the trade is favorable because they can enter a short at a price that’s higher than the market and simultaneously get paid funding due to the skew.

A smart trader could long 1 BTC spot on another exchange at $55,500 and short 1 BTC on MCDEX at $56,300. The trader is hedged to price exposure and captures both the funding rate and an arbitrage spread.

Mai Protocol v3 also uses the concept of operators to incentivize people to set up more markets. An operator is an entity who uses Mai Protocol to deploy a perpetual swap market. They’re responsible for setting initial risk parameters and bootstrapping the market with initial liquidity. Every operator has to decide which oracle the market will use as an index price, and they also have to pay for the oracle. For all of this effort, operators receive a management fee on each trade — a parameter they can set themselves. An operator can at any time decide to rescind their role and pass on the authority to someone else. If a market has no operators, then the pool is controlled via LP governance.

Given the sheer number of exploits in the past year where oracles were the attack vector, there’s a lot of risk in a model where operators are free to use anything they want as an oracle. If the oracle feed can be moved by large percentages to create extremely volatile conditions, the AMM could gain a significant amount of one sided exposure that could cause either serious losses or insolvency.

Users on MCDEX will have to exercise diligence and ensure any markets they interact with use a reliable oracle. If the oracle is a Uniswap or Sushiswap TWAP, traders will also have to monitor the state of that pool alongside the perp market they’re using. Every pool on MCDEX, however, is insured to the capacity of the insurance fund. Fees from liquidation penalties are used to grow the insurance fund.

The protocol’s native token, MCB, is a governance token that gives an owner the right to participate in the MCDEXDAO. All fees paid to the protocol are captured by the MCDEXDAO, and thus owned by MCB holders by proxy. As a result, MCB token economics are similar to Uniswap’s, with a community treasury and governance rights.

Futureswap

Not much is publicly known about Futureswap besides the fact that it’s an XYK AMM for derivative products. Futureswap uses meta-transactions to create what it calls a “layer 1.5” protocol.

The project’s documentation claims it’s a Uniswap for perpetual swaps, but without the high slippage. Futureswap uses a dynamic funding rate to concentrate liquidity around the current market price. This is akin to MCDEX v3, but uses funding as the main peg retention mechanism.

Funding rates and fees are effectively baked into the price of perps on Futureswap. As traders enter more longs, an arbitrage opportunity to short an asset on Futureswap and long an equivalent amount of the asset on another exchange arises.

However, due to the pools composition being 50-50 in the base and quote assets, solvency risk for LPs is much lower than MCDEX. When perps are balanced 50-50, there’s no trouble with either model. All of the perp risk is offset by each other so Futureswap LPs own their value in two assets, while MCDEX LPs own their value in just the quote asset.

But this relies on the AMMs long and short exposure being balanced at 50-50. In the event where there’s a small skew, that changes. Let’s say it’s a bull market and traders are constantly skewed long BTC. MCDEX and Futureswap LPs are thus long the assets they deposited in the pools, but are also short via their exposure to perps as a counterparty. Futureswap LPs own 50% of their value in BTC, so the risk from their short exposure is minimized. MCDEX LPs own 100% of their liquidity in USDC, which has kept their impermanent loss at 0 so far but now exposes them a lot more price risk if BTC price keeps going up and the long-short skew doesn’t balance.

In most cases, I would wager the ratio of longs and shorts stays close to 50-50 due to how easy it is to execute a basis trade. And in this scenario, assuming fees on both DEXs are the same, MCDEX LPs will make more money than Futureswap LPs due to lower impermanent losses. However, Futureswap LPs are also relatively shielded from black swan events due to their balanced spot exposure.

All trades on Futureswap have a flat 0.1% fee, and liquidation fees are fairly steep. Liquidations on Futureswap are akin to MakerDAO. An external liquidator submits a liquidation transaction, the protocol checks the position to see if it has crossed it’s liquidation threshold, and the protocol liquidates the position if it has.

30% of the position’s collateral is paid to the liquidator as a reward, 5% is retained by pool to recapitalize itself, and 65% if given back to the owner of the position. A 35% liquidation penalty is quite steep, and if Maker’s current process is any indication, these penalties could end up being much higher than 35% in reality.

The 30% fee to liquidators is subject to protocol governance and is likely to be much lower as Futureswap v2 opens up on mainnet.

Futureswap’s native FST token is a governance token that votes on protocol risk parameters, adding new markets, and other decisions. FST cannot be bought or transferred at the moment — it can only be earned by using Futureswap as a trader or an LP. 40,000 FST are issued per day, with 65% of that going to traders and the remaining 35% to LPs. There is currently no mention of the token capturing value via fees.

AlphaX

Alpha Homora is a financial protocol that enables leveraged yield farming. The project has mustered significant traction and will be launching AlphaX, a tokenized perpetual swap issuer, in Q2 2021.

The concept of a continuous funding rate is abstracted in AlphaX. A fixed funding fee is baked into the price of a perp and is paid by traders when they open a position. AlphaX’s perps will also be tokenized as ERC-20 tokens. This makes them transferable, and opens up the possibility of AlphaX perps being used as collateral in other DeFi protocols. Using leveraged perps as collateral isn’t the safest idea, but it furthers the idea of “superfluid collateral.”

At the moment, AlphaX is live on a private testnet as the team continues to develop the product. AlphaX is expected to ship on mainnet later this year.

Synthetix

In a way, Synthetix’s spot synths are already “perps”, they just aren’t levered yet. As part of the Synthetix V3 redesign, the team emphasized their focus to deploy on a layer 2. As a result, Synthetix opted to allocate a significant chunk of their resources to working with Optimism and getting a functional layer two 2 sooner rather than later.

A recent delay means Optimism is now predicted to go live on public Mainnet by July, although this date is subject to change. Synthetix staking has already been migrated to the L2, and the exchange contracts are expected on L2 soon. The focus for now is to get the exchange functional on L2 and then deploy levered synthetic perps. The release of Synthetix’s perps are expected sometime in Q3 2021 once Optimism is fully live.

Synthetix’s perpetual swaps will utilize the same model as spot synths. SNX stakers form the universal debt pool, and the debt pool is the counterparty to all perps issued. However, for SNX stakers as the counter party, an equal 50-50 exposure to longs and shorts of all perp markets is ideal, as their directional exposure to each side is offset. Synthetix will utilize a funding rate to incentivize that stakers have market neutral exposure.

Once perps are live, Synthetix will have no problem setting up multiple markets as they already use over 20 Chainlink price feeds for spot synths. But determining which markets have enough demand is important too. For example, an sDEFI perp could be difficult to arbitrage because it’s an index developed by Synthetix. Binance and FTX DeFi indices have different asset compositions. Traders taking a basis trade in an sDEFI perp would have to individually hedge each asset in the sDEFI index.

Kine

Kine is a derivatives protocol that enables cash-settled instruments to be issued against a variety of collateral assets. We should highlight that Kine is taking a hybrid approach which differentiates it from the field. It combines 0n-chain staking, a common DeFi mechanic, with effectively a centralized exchange built on top of it for trading. The staking function is live on Ethereum mainnet, but the exchange is yet be deployed. When Kine launches its exchange, all trading will be off-chain and thus centralized for the near-future. The project’s plan is to eventually migrate the exchange to a layer two after deploying on mainnet. However, it’s unlikely that this will happen before Synthetix or other competitors launch on L2 given the time they’ve spent in development.

Anyone can post collateral into the Kine system and mint kUSD for up to 80% of the collateral’s value. kUSD is then used on the Kine Exchange as collateral for trading in various perp markets. Kine’s derivative contracts are CFDs that are settled in kUSD. The system architecture is similar to that of Synthetix; Kine uses oracles to facilitate zero-slippage swaps and uses a universal debt pool to be the counterparties to all traders on the Kine Exchange. It differs in terms of supported collateral, where Synthetix mainly uses its native token, SNX, as a collateral asset and Kine focuses on leveraging existing crypto assets as system collateral for the debt pool.

Currently, Kine’s documentation suggests the protocol will support many collateral assets and simultaneously calculates the debt limit as 80% the USD value of assets locked by a user. An obstacle with enabling a large number of collateral assets is the need to conduct risk assessments for each asset. Aave has detailed risk assessments and customized risk parameters (maximum LTV ratio and liquidation thresholds) for each of the 20+ assets on the protocol.

Using generalized risk parameters, like a fixed 80% debt limit, for all of the assets in the protocol would amplify solvency risks, as the system is only as strong as the weakest form of collateral. For example, if both ETH and MANA depositors have the same collateralization ratios and liquidation thresholds, the system treats both assets as the same. And that means Kine wouldn’t recognize the difference in both assets risk profiles. Volatility, liquidity, and other risk measures are thus ignored.

Kine recently ran a Liquidity Boostrapping Pool (LBP) on Balancer, selling 5% of the token’s supply (5 million KINE) to the public and raising close to $20 million in the process.

Vega

Most of the derivative protocols highlighted so far are dApps building on Ethereum / L2. Vega, however, is an independent app-chain purpose built to issue and trade derivatives. The Vega blockchain uses Tendermint consensus and is built using the Cosmos SDK, making it interoperable with other blockchains built using the Cosmos SDK (Terra, THORChain, etc.).

Vega will support several types of derivatives with customizable market parameters. Each market will have its own risk parameters, contract specifications, and oracle. The exchange will use an on-chain orderbook and will be able to settle markets in a variety of assets — including ETH and ERC-20 tokens via a bridge to Ethereum.

The goal of Vega is to build scalable and flexible infrastructure to issue and trade derivatives on. Currently, the exchange is live on a public testnet that connects to Ethereum’s Ropsten testnet via a bridge. Vega does not currently have a live token, but will release its governance token in the near future.

Injective Protocol

The Injective Protocol is another independent blockchain to issue and trade derivatives. The base infrastructure is similar to Vega; Injective uses an on-chain orderbook and the chain is built using the Cosmos SDK.

Injective refers to itself as a “layer two sidechain” (even though sidechains are not layer two solutions) that is interoperable with popular blockchains like Ethereum. Not much is known about the long-term roadmap and vision of Injective, but the protocol will start out with CFDs and perpetual swaps when it launches on mainnet.

The exchange is live on testnet and has announced several partnerships with smart contract platforms like Avalanche and Moonbeam. Injective is focused on bridging with other networks and bringing derivatives to each of those platforms. Given the recent proliferation of dual-launches on Ethereum and BSC, this approach is a smart way to infiltrate up and coming networks that could attain a larger user base over the next year or so.

INJ, the network’s native governance token, is used to decide on exchange parameters and network upgrades. There is no value accrual via fee capture per the project’s documentation, but this is likely to change in the future. At a $163 million market cap and $1.1 billion fully diluted valuation, INJ trades at a rich valuation relative to the progress the project has made.

DerivaDEX

Similar to dYdX, DerivaDEX is a derivatives exchange launching on Ethereum that utilizes on-chain settlement with an off-chain orderbook & trade matching engine. However, the project claims to be fully decentralized by leveraging trusted hardware to bring a CEX-like UX to DEXs. DEX Labs is the team developing the DerivaDEX, but they claim the project’s ownership is in the hands of the DerivaDAO from day one. There isn’t much information on how the hardware set up works, but I assume it runs specialized software to host and run the exchange’s orderbooks.

A liquid and large insurance fund is a necessity for any derivatives product to ensure the solvency of the exchange during black swan events. DerivaDEX launched an “insurance mining” program where anyone can stake stablecoins like USDC and USDT and earn a reward in the protocol’s native DDX token. 2.5 million DDX (2.5% of total supply) have been deployed to bootstrap insurance mining between Dec. 2020 and Dec. 2021. This is similar to Aave’s safety module where anyone can stake AAVE to backstop the protocol’s money markets. However, DerivaDEX backstops its markets with staked stablecoins rather than its own token.

DDX’s supply break up is split 50-50 between insiders (team, investors, and advisors) and the community. It’s a governance token that powers the DerivaDAO. Holders of DDX effectively decide the parameters of the DerivaDEX and how the exchange should grow/scale.

Serum

Serum is an all-purpose liquidity protocol built by the FTX Exchange and Alameda Research on the Solana blockchain. Serum is powdered by native orderbooks and, thanks to Solana’s high throughput, said orderbooks are fully on-chain. You can think of Serum as the liquidity core of Solana, with a bunch of Graphical User Interfaces (GUIs) built on top of it. For example, Bonfida is a GUI that directly plugs into Serum’s spot market orderbooks. Raydium is an AMM built on top of Serum, using the protocol’s liquidity to swap trades for its users.

Serum can cater to both spot and derivative markets. However, it seems there are no GUIs that tap into Serum’s perpetual swap orderbooks yet. Serum has attracted world class market makers like Jump Trading in addition to the crypto-native Alameda Research. The existence of sophisticated market makers guarantees high liquidity on certain pairs. This can be expected to play out as the Solana ecosystem grows and attains more users.

Concluding Remarks

Currently, a lack of scalable infrastructure is the biggest obstacle to decentralized derivative usage. With layer two solutions like Optimism, Arbitrum, and StarkWare launching in the coming months, this obstacle is closer to being abstracted than most realize.

The launch details of Uniswap v3 last week has spurred a lot of discussion regarding the concept of concentrated liquidity. MCDEX and Futureswap use a type of concentrated liquidity mechanism that is well-suited for perps. Uniswap Labs estimates capital efficiency from their mechanism to increase by up to 4000x. If true, this validates the approach to pricing taken by both MCDEX and Futureswap.

Limit orders are an important feature for any market, but more so for derivative markets where participants are often highly levered. When it comes to limit orders, orderbooks are the winner as there is a clear-cut method of implementing a wide range of limit orders (stop orders, fill or kill orders, good till cancelled orders, etc.). AMMs like Perpetual Protocol are developing on-chain limit orders, but we won’t know if they’re nearly as efficient as limit orders on dYdX until this feature ships. Others AMMs like MCDEX are building off-chain limit orders that can be submitted by running a specialized piece of software called a “broker server.”

Cross-margin is another key feature that boosts capital efficiency and lets derivative traders exercise flexible risk management. Under cross-margin, a trader can use a single pool of capital as margin for all of their positions. Unused margin from one account can be used to secure positions in another account. The other method of margin is isolated margin, where a trader must post their initial margin (5-10% on average) and the position is secured against this. Under isolated margin, traders are at higher risk of liquidation and losing their margin.

AMMs focus on silo-ing risk for a market within that specific market so it doesn’t leak into the rest of the exchange. For this reason, DEXs like Futureswap and MCDEX don’t support cross-margin positions. dYdX is the only live derivatives DEX with cross-margin, and Vega will also support cross-margin once live.

Zero reliance on centralized infrastructure like cloud storage is obviously better from a decentralization/censorship resistance perspective. This is why off-chain orderbooks and matching engines do not have the same degree of resiliency as a fully on-chain AMM. However, it’s undeniable that orderbooks are more efficient and functional for perps in their current form. This is why projects like Serum, Injective, and Vega that use on-chain orderbooks are exciting. But, once again, there are decentralization concerns as the base layers would need a diverse set of validators to be truly permissionless and censorship resistant.

I have no doubt decentralized derivatives are going to be one of DeFi’s strongest narratives this year. The size of the addressable market is incredibly high and decentralized exchanges will continue trying to eat into the market share of centralized exchanges. Ultimately, capturing that market share boils down to whether decentralized exchanges can offer a better UX than their centralized counterparts. We believe they can.