Clearing technology allows vertically integrated DeFi prime brokers to give DeFi market share a chance to overtake centralized exchanges, but they also face the test of agreement risks and clearing risks.
Written by: Parsec Research, research department under parsec.finance Compiler: Perry Wang
parsec.finance authorized chain news to translate and publish the Chinese version of this article.
In traditional finance, when users click “buy” on the screen, they will get a seamless experience that they can access financial products in a few seconds. Behind the scenes, a large number of financial engineering and infrastructure provide this seamless experience. A distributed system problem arises among algorithmic traders, brokers, investors, rich regulations, and dozens of other intermediaries.
Decentralized financial DeFi reverses this situation by allowing near-instant settlement and direct custody. That being said, as open financial primitives continue to evolve, aggregate prime brokers such as protocols will emerge, squeezing inefficiencies from the market and greatly increasing liquidity , Thereby improving the utility of the entire market. The core question is what exactly are these agreements?
The community began to discuss this, and the value narrative has tended to extend the existing DeFi protocol by providing more and more financial products and protocol levels, using rehypothication and margining. Dan Elitzer Yam Finance, one of the founding members of the team about support farming symbiotic cultivation of income (aquaponic yield farming) research and one of the promoters of Trent Elmore of YAM this wonderful comic pushed very good embodies this vision, and Synthetix This is the most obvious example of action already taken in this direction [ 1 ]. However, my goal in this article is to devise another way to differentiate the issuance of assets and derivatives from services such as prime brokers.
Under certain conditions, financial markets become highly liquid. The first is the real demand and transaction flow. The record DEX transaction volume further highlights the increasing number of DeFi fields that see this trend [ 2 ]. But the second condition is the risk infrastructure of the derivatives market and related clearing and settlement forms. The simplest clearing example is: an arbitrage trader goes long BTC on exchange A with 10 times leverage, and short BTC on exchange B with 10 times leverage. Due to the offset nature of the position, he/she does not need to provide full collateral (or even fundamental No mortgage required). For traders trading on centralized crypto derivatives exchanges like BitMEX , the cross margin provided by these exchanges is a simple example of this type of risk infrastructure. The limiting factor of this mechanism is that it only applies to that single exchange. Once liquidation is introduced, hedge funds, quantitative trading institutions and traders can hedge and arbitrage with incredible capital efficiency.
Examples of efficiency gains from liquidation
The centralized encryption market has quickly stacked up a derivatives market on top of this emerging industry, with the most eye-catching futures and perpetual contract futures trading. However, liquidation still lags far behind traditional financial standards. There are some reasons why this infrastructure does not appear in centralized encrypted transactions, all of which require a longer explanation, but to make a long story short, it does not exist yet, this is a centralized exchange that dominates DeFi curve overtaking CEX market share brings opportunities.
First consider the vertically integrated DeFi prime broker or ” liquidity black hole “. Assuming that the agreement issues derivatives and synthetic assets, clearing technology can be used for effective transactions, which can calculate the required net position value by offsetting, which is very important from the user’s point of view, because they can keep all funds in one System. However, in combination with liquidation and issuance, the agreement hierarchically assumes two separate risks.
The first is agreement risk , including maintaining the core competitiveness of financial primitives. What is the degree of anchoring of synthetic assets and secured assets such as DAI or sBTC, and what mechanism is needed to realize their value? For option contracts, what is the guarantee of exercise ability? Cash settlement or physical settlement? For the prediction market, who decides the outcome? Does the oracle need streaming data or one-time settlement? Has the contract been fully mortgaged? All of these are based on actual smart contracts and basic layer security.
On the other hand, liquidation risk is an abstraction of agreement risk , an engine that produces assets that are considered similar or offset assets and willing to fulfill the user’s position. Each agreement represents a unique set of tail risks for the clearing agent. Any client of a brokerage institution hopes to price the agreement risk ruthlessly and fairly, so as to avoid bankruptcy when the agreement goes wrong. Equally important for risk elimination is the actual modeling of related but distinct products. Consider the share of the liquidity provider LP in the ETH/DAI liquidity pool and the 10 times longer BTC/USDC dydx perpetual contract. Calculating low risk and effective compensation here is not easy, and it requires skilled modeling of derivatives and their underlying layers.
The point here is that the risk takes different forms. Entities trying to mitigate these two risks have different goals. The goal of the agreement is to provide economic security, firm anchoring, settlement guarantees, etc. And clearing brokers provide a probabilistic method for solvency. For example, as long as the fees charged are greater than the risk they bear in the liquidation position, they have solvency and profitability and can continue to exist. Many agreements do take probabilistic risks in the process of default operations, but these risks are concentrated risks and must be resolved through the framework of the agreement! The vertically integrated DeFi protocol we are discussing bears these unique risks hierarchically, exacerbating its bankruptcy risk. This is not to say that internal liquidation of the agreement should not be carried out: For example, Opyn is trying to reduce the margin for option portfolios such as spreads to improve capital efficiency [ 3 ], which they should have done! Any option issuer needs to perform intra-agreement liquidation to maximize efficiency. The point is that the Opyn system should not continue to offset the position of sETH or ETH/USDC LP shares, because this will bring a whole set of risks that are not related to the core business of the agreement.
Let’s talk about the DeFi prime broker. Brokers are not loyal to any agreement, but are only loyal to risk models that assess the interchangeability of various assets and portfolio returns. The broker will allow to reduce the margin for long sBTC positions and short BTC-PERP positions. The result is narrowing of spreads and increased liquidity on all assets/markets cleared by brokers. What will it actually look like? The broker accepts any collateral that it knows at a high level. As a trader, you may just deposit cash assets, whether it is USDC, ETH or synthetic BTC. Once the funds are deposited, the broker will match the transaction and credit/debit your account when you trade. In order to actually provide settlement at the time of exit, the broker will need to hedge the position through the interaction of the main chain and the corresponding agreement. Those who wish to continue to use the core agreement now find that the market is more liquid as the broker feeds funds back into the underlying agreement. Ideally, there are multiple DeFi clearing brokers, each with different products and risk settings, and provides services for each level of the user’s risk range.
DeFi Prime Broker Process Diagram
The obvious problem is privacy. The broker’s hedging process will be preempted by experienced participants. They will see the big transaction words inside the broker and will be the first to intercept the hedging input by the broker. It is not yet clear what real mitigation methods can solve this problem, whether it is dark pools, privacy brokerage positions, over-the-counter transactions through aztec assets, etc… In fact, it may also be a combination of all the above factors. In order to keep DeFi’s core merchants unscathed, the new financial system must remain open and checkable at the same time, while also ensuring the ability of traders to enter and exit positions privately. This is a unique and high requirement.
From an architectural perspective, the system needs to sacrifice a certain degree of decentralization to achieve this capital efficiency. The ledger maintained by the broker will need to customize some rules in terms of position size and withdrawal waiting time. The ideal situation is to implement this type of actual transaction by a high-speed second-layer L2 trading system like ZK Rollup , or any latest and greatest L2 design. As Ethereum gradually transitions to ETH 2.0 and sharding, L2 structures like this become more attractive. Aave can be deployed on one shard , Synthetix on another shard , and Augur on another shard . Because brokers have already assumed the risk of delay, they are more capable of handling the complexity and asynchrony of cross-sharding contract calls and communications.
If the open financial system wants to flex its muscles, it needs to avoid the mistakes of its predecessors. The agreement may fail, the aggressive trading broker may fail, and there is no bottom line but the only profit is that funds may swarm in and suppress your favorite tokens to zero value. The most important thing is to ensure that there are no sleeping giants and that the entire system will not be disrupted when this risk is released. How to avoid the global financial crisis of DeFi? There must be no Lehman Brothers or Bear Stearns that can bring the entire system to the brink of collapse.
Parsec Research is the research department of parsec.finance. Thanks to Eli Krenzke for his feedback on this article.
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