Tushar Jain, Managing Partner of Multicoin Capital, explained the advantages and disadvantages of various decentralized derivatives agreements in the market. He believes that the sustainable model will be the ultimate “winner”.
Extended reading: ” Looking for the next DeFi hotspot: a multidimensional comparison of decentralized perpetual contract products on the six DEX platforms “
Original Title: ” Multicoin Capital: Competition and Trade-offs in the Decentralized BitMEX Track ”
Written by: Tushar Jain, Managing Partner of Multicoin Capital Compilation: Free and Easy Source: Babbitt
Written in front: The original author TUSHAR JAIN is the managing partner of Multicoin Capital. In this article, he outlines the opportunities in the synthetic asset market and compares the advantages and disadvantages of existing agreements in the market. In his view, the adoption of perpetual The model’s decentralized exchange protocol can stand out from the crowd. In addition, he also analyzed the trade-offs of related protocols in terms of security, liquidity, decentralization, and oracles.
This article assumes that you have learned about crypto derivatives and major DeFi protocols.
One of the biggest innovations in the modern financial market is that traders can obtain financial exposure to a certain asset without having to settle the asset physically. This is the so-called synthetic exposure. This greatly expands the trading range of traders and can also help reduce volatility and increase liquidity.
We believe that the biggest and most profitable opportunity for DeFi is to create an agreement that allows anyone in the world to trade any asset. For more than a year, we internally called this idea “decentralized BitMEX”. The idea of implementing a decentralized trading protocol for synthetic assets is very convincing for several reasons:
- There is no centralized exchange operator, so the cost is lower in the long run;
- No permission required for access;
- Anti-censorship features, so that no one can close the exchange;
- There is no counterparty risk, because users hold funds themselves;
- No withdrawal restrictions or transaction size restrictions;
- There is no way to unilaterally change the rules of the exchange;
- Any asset with a public price feed can be traded;
Today, centralized cryptocurrency exchanges process USD 3 billion of spot trading volume and USD 13 billion per day of derivatives trading volume every day. In contrast, global equity trading in the first quarter of 2020 has a transaction volume of US$32 trillion. At the end of 2019, the global foreign exchange transaction volume reached 6.6 trillion US dollars per day. A permissionless synthetic asset exchange built on the orbit of cryptocurrency will allow anyone on the planet with an Internet connection to gain exposure to any financial asset. This will greatly expand the asset exposure market, just as Uber expands the taxi market.
At present, there are already many teams in the DeFi field dedicated to building a decentralized BitMEX, and these teams have adopted different approaches in protocol and contract design. In this article, we discuss the design space of decentralized BitMEX and the choices made by outstanding teams trying to build the future. Our main concern is financial construction, not technical architecture, so the focus of this article is on finance, not software.
The goal of synthetic asset trading
The main goals of the decentralized BitMEX protocol are:
- A highly liquid market;
- Achieve a moderately high leverage ratio;
- Always keep the contract price close to the fair asset price;
- Have a powerful liquidation engine to prevent bankruptcy and social losses;
- Provide the lowest transaction cost (at the application and protocol level);
- Low-latency transactions;
- Support a variety of convenient and stable collateral types;
- Cross margin position;
- The ability to provide synthetic exposure to any asset;
- Real chain decentralization, or at least complete transparency;
We believe that the best way for a synthetic asset DeFi platform to attract liquidity is to optimize the above ten characteristics. However, this is very complicated and there are many trade-offs that must be considered.
Overview of major synthetic asset agreements
There are already some DeFi structures that can be used to produce synthetic financial structures, and each has its own advantages and disadvantages.
Maker, Kava, BitShares-collateral-backed assets + oracles
In this structure, users withdraw debt from the asset pool. Debt is synthetic. In order to manage creation, redemption, and liquidation, the system needs an external oracle. This is the simplest synthetic asset construction. Including Maker and BitShares have adopted this model. The use of small market value assets as collateral (Synthetix, BitShares) agreement must require a higher mortgage ratio to deal with volatility risks.
Advantages: simple, concentrated liquidity; Disadvantages: capital efficiency is not high, the available leverage ratio is limited, external oracles are required, and the anchor cannot be maintained due to the lack of arbitrage cycles.
UMA + Priceless contracts
Similar to the above structure, the trader deposits collateral and extracts synthetic positions against the collateral. However, the construction of this priceless contract is different in several aspects: (1) the position does not have to be fully mortgaged, (2) the use of external oracles is replaced by a crypto-economic game that can incentivize Traders and liquidators do not lie about asset prices (note: this model was pioneered by UMA).
UMA provides a general framework for instantiating contracts and resolving price disputes. However, UMA is not a product. A few teams have developed products and services on UMA, including Potion and Jarvis.
Advantages: higher capital efficiency, can be extended to almost any asset, debt risk is limited to one collateral pool; Disadvantages: the oracle game wheel is a new untested theory, the oracle is slow and cannot be used in real time In cascade liquidation, liquidity is scattered.
Augur, Gnosis, Polymarket and Flux-prediction markets
The prediction market provides the ability to speculate on the outcome of future events. The most common examples are binary options: sports, politics, month-end/quarter/annual price forecasts. For example: “When the market closes on December 31, 2020, will Tesla’s stock price be higher than $2,000?”
Companies like Augur, Gnosis, Polymarket, and Flux have adopted this model.
Advantages: High capital efficiency, optimized for events such as politics, sports and EOY price forecasts. Disadvantages: It requires an external oracle, it is difficult to construct a simple synthetic asset to reflect 100% changes in the underlying price, the leverage is limited and relatively inflexible, and the liquidity concentration is low.
Opium-cash settled futures
In this model, the trader transfers the margin to a smart contract, and then buys or sells a futures contract that is settled at a certain time. The futures price will converge to the underlying index price during settlement, because there is an arbitrage transaction, it will buy spot and sell futures, and vice versa. Opium uses this model in its futures contracts. This model is very similar to traditional futures contracts in the old world financial markets.
Advantages: simple and easy to understand, high capital efficiency, providing high leverage, allowing option market makers to hedge positions, allowing miners to lock in the hedging period; Disadvantages: dispersing liquidity on different expiration dates requires external oracles, no The index price must be tracked during the contract period;
Synthetix-Perpetual swap based on debt pool
Perpetual swap traders trade with the SNX debt pool. Therefore, unlike traditional perpetual trading models, traders do not need to wait for counterparties to match their transactions. Long and short positions are not always balanced, which means that excess funds will be paid to SNX pledgers to make up for the risk that one party to the transaction is more profitable than the other. Only traders who increase the deviation between long and short positions will pay transaction fees.
Advantages: Traders do not need to wait for counterparties, provide a high leverage ratio, ensure liquidity, do not need market makers, and are easy to guide liquidity; Disadvantages: Capital efficiency is low. If the trader makes a profit, the SNX pledger will In trouble;
Perpetual Agreement-Perpetual swap based on virtual automated market maker (vAMM)
Traders deposit collateral into smart contracts, and they trade synthetic assets up and down the joint curve. The financing rate is determined by the difference between the bid price set by the external oracle and the index price. The algorithm setting of k is a function of trading volume, open interest and other variables. Please note that in this model, there is no maker, everyone is a taker, and the perpetual agreement is the model adopted.
Advantages: simple and easy to understand, high capital efficiency, provides a high leverage ratio, ensures liquidity, concentrates liquidity, does not need a maker, and is easy to guide liquidity; Disadvantages: an external oracle is required to determine the financing rate, which is required An insurance fund with sufficient capital.
DerivateX, dYdX, MCDEX and Serum-central limit order book (CLOB) perpetual swaps
Traders deposit collateral into smart contracts, liquidity providers issue limit orders on CLOB, and takers cross the spread. DerivateX, dYdX, and MCDEX adopted this model and created an off-chain CLOB on Ethereum. The Serum project also adopted this model and established an on-chain CLOB on Solana.
Advantages: easy to understand, high capital efficiency, provides high leverage, provides the tightest spreads, and concentrates liquidity; Disadvantages: it is difficult to guide liquidity, because it requires mature market makers, in addition, it also needs An insurance fund with sufficient capital and external oracles are required to determine the financing rate.
Explore non-custodial perpetual swaps
When studying various types of synthetic structures in DeFi, it is clear that perpetual swaps AMM, debt pools, or order books are the best designs for decentralized BitMEX. Perpetual swaps allow financial contracts to closely reflect the underlying conditions and provide sufficient leverage. This has been widely used and understood in crypto and traditional asset classes, and can support any asset by feeding prices.
Although perpetual swap contracts are not perfect, their weaknesses are manageable. On the contrary, the weaknesses of other models are more difficult to overcome: the capital efficiency of the collateral-backed asset + oracle model is inefficient, and the debt pool model cannot be well anchored (see DAI and sUSD prices in the past 24 months), and the forecast market is not It is universal, while the priceless contract model is very slow due to the risk of cascading clearing, while the futures model will spread the liquidity between each maturity date, which is more suitable for complex hedging rather than speculation (total In general, the sustainable model is easier for retail investors to understand and trade).
Since we believe that the perpetual exchange will be the “winner” of the decentralized BitMEX track, we will study the trade-offs of non-custodial perpetual swaps below.
Safety VS Liquidity/Leverage Ratio
The most important trade-off is between safety and liquidity/leverage. We say liquidity/leverage ratio because, according to the data, platforms that provide higher leverage ratios have greater transaction volume and liquidity:
Bitcoin perpetual trading volume VS Bitcoin spot trading volume, data source: Interdax, Tradingview
An important consideration in the trade-off between security and liquidity/leverage is the loan-to-value ratio (LTV) requirement of the platform. On MakerDAO and Compound, users can only get 66% of the loan-to-value ratio (1.5 times the mortgage rate), while BitMEX users can get 10,000% of the loan-to-value ratio (100 times the leverage, which is 1% mortgage) rate).
A lower loan-to-value ratio (LTV) brings better security, but it also limits the leverage ratio, thereby reducing liquidity.
When it comes to these trade-offs, there is no “correct” answer. An exchange that optimizes too much for safety will lead to inefficient capital and insufficient liquidity, making it impossible to compete with other competitors in the market. An exchange optimized for excessive leverage can be very dangerous.
At least, centralized cryptocurrency exchanges can provide a leverage ratio of 3-10 times and can keep the liquidity underlying assets relatively low in liquidation risk. Limiting it below this range will greatly increase capital requirements.
Although this is expressed in terms of futures leverage, the loan-to-value ratio (LTV) is a similar parameter for deliverable spot margin trading (for example, Compound, Aave).
Concentrated pool mortgage vs isolated market
One of the main differences between UMA and Synthetix is that collateral and debt exposures are isolated in UMA, while all LPs in Synthetix group them together. For example, if any synthetic token trader makes a profit, all SNX pledgers in the Synthetix ecosystem will face losses. In fact, a single collateral pool provides higher liquidity and collateral efficiency, but it also means that if traders make a lot of profits, then the entire system may be unable to pay debts.
UMA chooses to isolate collateral by market, which means that if a trader wants to trade in multiple different UMA markets, they need to provide collateral in each market. This obviously generates significant friction, which reduces fluidity. On the other hand, this means that traders only need to bear the risks of the market they are trading, instead of covering the entire liquidity pool of hundreds of assets.
There are also potential capacity tradeoffs here. The cross-margin market needs to coordinate risks and limit the ability of traders to trade at the same time, thereby limiting the effective order throughput. This choice is a basic trade-off, and there are no gray areas. The agreement allows or does not allow consolidation of collateral, and the choice is binary.
Support multiple types of collateral
Supporting more types of collateral means that traders can trade more easily without having to purchase new assets as collateral. But this also means that other traders must bear the risk of additional collateral types. If the value of the new type of collateral plummets, the entire system may go bankrupt.
dYdX chose the safest option, it only allows a single type of collateral: USDC. On the other hand, MakerDAO allows more types of collateral because the system provides leverage for a wider range of traders. However, this also increases the risk of financial system bankruptcy, as it did on March 12.
In contrast, FTX supports 19 collaterals. Each sub-account on FTX has a central collateral pool, and these funds are used for cross-margin positions. Today, hedging positions on the same basis does not reduce collateral requirements (for example, unhedged net positions). However, we expect the team to achieve this goal over time, either using internal computing agents or using tools like X-Margin.
A strategy for safely supporting multiple collaterals is to set governance limits on the maximum percentage of the collateral pool that an asset can own. The protocol designer can also require a higher mortgage ratio to cope with more unstable assets.
In addition, different forms of collateral will bring different degrees of risk. The use of stablecoin collateral (such as dYdX) is usually the safest, so leverage can be maximized. Using a single liquid asset (such as what Maker did before (ETH) or what BitMEX still does (BTC)) will double the damage to the system in the event of a severe crash. The use of low-liquidity (SNX) protocol tokens like Synthetix is very risky, because collateral tokens may undergo a special collapse, so a higher mortgage rate level is usually required.
Positiveness for liquidation
A more aggressive clearing engine will protect insurance funds more effectively and capitalize them over time and protect winning traders. The less active clearing mechanism is less painful for traders to clear because they will retain more capital.
The more aggressive liquidation engine will fully liquidate the position as soon as the liquidation price is reached, while the less aggressive liquidation engine will only liquidate part of the position (often called incremental liquidation). For example, FTX performs incremental liquidation, while Binance performs full liquidation. For traders, this can bring huge changes. For example, if a trader has the same 20x leveraged position on FTX and Binance, then FTX will liquidate its collateral to the maintenance margin, and Binance will liquidate the entire position.
When a trader approaches the liquidation price, a less aggressive liquidation engine will liquidate the trader’s position, and a more aggressive engine will complete the liquidation faster. For example, Synthetix will liquidate when the trader’s collateral is less than 200%, and when Maker’s ETH mortgage rate is less than 150%, it will liquidate.
More aggressive liquidation engines may cause price chain reactions. For example, on March 12, BitMEX’s liquidation engine crushed the price of BTC. On this day, BitMEX liquidated long orders of more than $1.6 billion, and if BitMEX did not ” Maintenance shutdown”, then their clearing engine may push BitMEX’s BTC price down to $0.
The best way to measure the aggressiveness of a clearing engine is to check how long the clearing engine will last before clearing liquidity and pushing up prices.
In addition, higher clearing fees and more aggressive clearing engines will inhibit the excessive leverage of traders, thereby reducing the amount of clearing. This means that the liquidity of the venue will be reduced, so for the maker and taker, the transaction cost will be higher. But this also means that the exchange will be safer for profitable traders, and the exchange is less likely to recover profits.
Flexibility vs simplicity
The second major trade-off is between flexibility and simplicity.
Bet against the entire system, or against other players
In some protocols (such as Synthetix), all traders are betting against the system. In other agreements (such as Serum or DerivaDEX), traders are betting against other traders.
This means that when there is more money to go long than short, the entire Synthetix agreement may become unbalanced, and vice versa. In an extreme example, if 100% of the traders on Synthetix are BTC-USD longs, and there is a gap in the BTC-USD price, then the entire Synthetix agreement may go bankrupt!
The asymmetric risk of this insurance fund means that Synthetix must require a higher collateral ratio and have a more active clearing engine than a system of gambling between traders.
On the other hand, an agreement to bet against the system makes it easier to activate liquidity because the system provides the supply side of the bilateral market. In agreements such as DerivaDEX or Serum, traders need someone to match their orders, otherwise they cannot trade. If professional market makers are unwilling to provide liquidity in the agreement, then this advantage of guiding liquidity is very valuable in the early stages.
Order book VS AMM
AMM allows liquidity providers to set and forget it, while the order book allows liquidity providers to have greater flexibility in providing liquidity.
AMM allows potential capital without market maker experience to use formulas to quote prices in two directions, rather than having each liquidity provider set prices manually. The important thing is that the formula itself is 100% open. As an incentive for capital contribution, liquidity providers can charge transaction fees. Since the AMM formula is always 100% open, experienced market makers can see the price and choose a tighter spread. Therefore, the order book model is always more liquid for high-quality assets for which market makers are willing to provide liquidity.
AMM is mainly used for long-tail assets: these assets are too small for more mature market makers.
Slow vs Fast Financing
The frequency of maturity or financing payments will affect the closeness between the contract price and the index price. More frequent expiration means that the contract will track the index price more closely because it will settle to that price faster, but it also means that traders need to trade more frequently. More frequent financing payments will have the same effect and push the contract price back to the original level, but it can be expensive to calculate.
Oracle
Oracle security VS oracle speed
Some derivatives agreements (such as UMA and Augur) have built-in oracle dispute resolution mechanisms. This can make the protocol more secure against oracle failure, but it increases the waiting time for traders to withdraw funds from the exchange. This is the basic trade-off between the oracle bankruptcy risk and liquidity risk. If the oracle fails and there is no built-in dispute resolution solution, the winning trader will have no recourse. However, if there is a dispute procedure, regardless of whether there is a dispute, the collateral will be locked, and the winning party cannot withdraw its capital. This opportunity cost means that traders are unlikely to trade in the trading venue.
For example, the oracle dispute period in Augur is 24 hours, which means that the winning trader will not be paid within 1 day after the event ends.
On the other hand, Synthetix uses Chainlink as its oracle, allowing traders to cash out immediately. But if the Chainlink oracle is destroyed, then traders who have been damaged due to the failure of the oracle will have no way to recover losses.
Maximum oracle movement
Some agreements limit the range of changes in the price of the oracle over a period of time. This can improve security in situations where the oracle is compromised and the price clears traders in an unfair manner. However, if the price fluctuates sharply, but the oracle does not, this may cause serious market distortions, thereby seriously threatening the solvency of the system.
Decentralization vs. Centralization
Decentralization is not a binary attribute, but a spectrum. The team building the decentralized BitMEX protocol must make multiple choices to determine their final position in the spectrum.
On-chain VS off-chain order matching
There are two basic ways to trade decentralized synthetic asset products: on-chain order matching + on-chain settlement, or off-chain order matching + on-chain settlement.
On-chain order matching provides review resistance and permissionless access. The off-chain order matching means that the operator of the centralized order matching system can (1) unilaterally and arbitrarily change the rules and fees of the order matching system; (2) review users or transactions.
0x pioneered the concept of off-chain order matching and was adopted by other protocols (such as dYdX). The benefits of off-chain orders are speed, delay and cost. On the Ethereum network, on-chain order matching is economically undesirable. Imagine that every time you place an order or cancel an order, you will be charged a handling fee of $20. This is unbearable!
Therefore, the agreement team built on the Ethereum platform is forced to use the off-chain order matching model, which sacrifices censorship resistance and permissionlessness, so that it can function on the severely restricted Ethereum network.
Layer 1 VS Layer 2
The current Ethereum network throughput limit is about 15 transactions per second, which is obviously very low and cannot support large-scale transaction activities. The recent surge in network activity has caused gas prices to soar above 200 GWEI. In addition, an Ethereum block is born every 15 seconds on average. Given the nature of PoW mining, this means that the transaction cannot be considered final confirmation for at least a few minutes.
At present, some spot exchanges have moved to the second layer (Layer 2) network (such as DeversiFi, Loopring). This is of course beneficial: transactions and settlements are faster, transaction costs are lower, and the risk of preemptive transactions is also less. However, there are obvious disadvantages in doing so, that is, these exchanges cannot use DEX aggregators (Matcha, 1inch, DEX.ag, etc.). It is impossible for 1inch to route the signed order part on the first floor to Layer 2 DEX, because the user must first deposit to Layer 2 DEX. In addition, moving to Layer 2 will make it more difficult for exchanges to support cross-exchange arbitrage, as this first requires depositing funds (which slows down the arbitrage process).
For derivatives exchanges, users must deposit collateral before trading. Therefore, they did not particularly benefit from existing aggregators. In addition, forcing users to deposit collateral in Layer 2 does not really hurt the user experience. This means that moving the decentralized BitMEX to Layer 2 does not have much disadvantage. Therefore, we expect that as the Layer 2 platform matures, most of the perpetual exchange agreements built on Ethereum will eventually migrate to Layer 2, and staying in Layer 1 will not benefit them.
Ethereum VS other Layer 1 networks
When choosing whether to build a perpetual exchange on the Ethereum platform, there is an obvious trade-off between composability and scalability. Ethereum has the most tradable collateral assets (ETH, USDT, WBTC, etc.) and more applications, so choosing Ethereum is more conducive to guiding liquidity.
However, Ethereum Layer 1 is currently unable to support large-scale trading activities. In this regard, FTX chose Serum, a newly launched decentralized derivatives trading system on Solana, which has been optimized for scalability and latency. At present, it is not clear which of the following two things will happen first: (1) Ethereum will expand, or (2) a reliable cross-chain solution to solve interoperability issues.
to sum up
Cross-border permissionless access expands access to global financial markets to billions of people around the world, and anyone anywhere in the world can trade any asset they want. With billions of people in developing countries accessing the Internet and entering financial markets, this will be an extremely expanding market.
The decentralized BitMEX ensures that no exchange operator or politically motivated regulator can unilaterally change the rules of the exchange, which means that traders all over the world can easily trade in the same place.
We believe that due to the strong network effect of liquidity and the reduced importance of traditional centralized services (such as customer support, localization, etc.), the decentralized BitMEX market will become a winner-takes-all market. For the team, it is very important and valuable to prepare as early as possible and start the flywheel by attracting liquidity providers and takers. As for the scope of financial trade-offs covered in this article, we believe that the early winners will evolve over time because they see what works and what does not work.
In the past 12 months, Multicoin has been looking for early decentralized BitMEX opportunities, and we have been actively deploying funds in this area. If the product you want to build meets the vision of decentralized BitMEX, we will be happy to hear from you.
Thanks to Sam Bankman-Fried for his feedback on this article.
Source link: multicoin.capital
