Crypto Derivatives LianGuairt 1 Perpetual Contract

Author: AMBER RESEARCH, Translation: Shan Ou Ba, LianGuai

Derivatives, especially perpetual contracts (“perps”), undoubtedly constitute the largest vertical sector in the cryptocurrency field, accounting for a significant portion of the overall cryptocurrency trading volume.

Almost all perpetual contract trading occurs on centralized exchanges. The irony of retail and institutional traders trading decentralized assets on centralized servers is not lost on many members of the crypto community. In the past few years, decentralized exchanges (DEXs) built on blockchain smart contracts have emerged. For those familiar with cryptocurrencies, DEXs like dYdX and GMX have garnered significant attention and are seen as viable alternatives to centralized giants. However, the trading volume and active users of these decentralized alternatives still represent only a small fraction of centralized exchanges.

Our team believes that decentralized derivatives trading will be a long-term growth area and will gradually take market share away from centralized exchanges. This report will outline our perspectives, with a focus on perpetual contracts, as they account for the majority of all derivatives trading volume. Firstly, we will examine the overall market structure of centralized and decentralized perpetual contracts. Then, we will explore the advantages and disadvantages of various DEX designs, particularly the feasibility of decentralized perpetual contracts relying on aggregated liquidity pools.

In the subsequent sections of the report, we will evaluate three upgraded versions of existing DEXs: GMX v2, Synthetix v3, and dYdX v4, building upon the foundation established in this report.

Introduction to Derivatives and Perpetual Contracts

Derivatives refer to financial instruments whose value is derived from an underlying asset. They exist in all markets. Contracts can track the value of anything from the S&P 500 index and gold to orange juice and weather.

Since derivatives are simply contracts that track value, they can be constructed with various different return profiles. The most common are futures contracts, which have linear returns similar to purchasing the underlying asset itself. Perpetual contracts, the focus of this report, have linear returns with 1x leverage.

In traditional markets, most futures contracts are time-limited. They expire on a specific date, and as the expiration date approaches, the futures contract price and the underlying asset price (referred to as the spot price) tend to converge. Prior to expiration, the futures price and spot price may differ, sometimes significantly.

However, in the cryptocurrency market, perpetual contracts are the most popular derivative product. As the name suggests, these contracts are perpetual. The price of perpetual contracts is anchored to the underlying price through a funding rate mechanism. Periodically, typically every hour or eight hours, funds flow from one side of the contract to the other.

For example, if there are more long positions on BTC-PERP, the price of the perpetual contract will be higher than the underlying BTC index price. To adjust for this, those holding long contracts must pay fees to those holding short contracts, incentivizing the perpetual contract price to match the index price. You can find a simplified and detailed explanation of perpetual swaps in this guide by LianGuairadigm.

The reason why perpetual contracts have become the preferred product may be due to the scarcity of liquidity in cryptocurrencies. Futures contracts with expiration dates distribute liquidity across multiple dates, while perpetual contracts consolidate all available liquidity of an asset into one contract. In this regard, perpetual contracts are relatively easier for retail investors to obtain.

Derivatives serve two purposes: hedging and speculation. But it is more helpful to consider why they exist (i.e. why participants do not directly hedge or speculate in the spot market).

There are two key reasons: inability to access the underlying assets and leverage. The high-friction spot market creates a demand for liquidity in the derivatives market. For example, selling wheat futures is much easier than shorting positions in the underlying wheat market (which may involve borrowing a large amount of physical wheat). In addition, derivatives trading is more capital efficient because traders can use leverage, only requiring a small portion of their capital to achieve nominal values that could be 20, 50, or even 200 times their margin. With $100,000, a trader can gain exposure to $5 million in assets through 50x leverage.

It is precisely because of the latter reason that perpetual contracts for cryptocurrencies have gained market share in the past five years. When BitMEX first created perpetual contracts for Bitcoin, it offered leverage of up to 100x, which means traders could lose all their capital in a 1% price fluctuation. In recent years, perpetual contracts have also expanded to various other crypto assets, allowing users to hedge or speculate on more difficult-to-access digital assets.

Underpenetrated vertical with long-term growth potential

Perpetual contracts are the most traded instrument in the cryptocurrency market. To provide a sense of scale, since 2021, futures trading on Binance accounts for approximately 75% of its total trading volume. Other non-US cryptocurrency exchanges have similar or higher proportions. For the US, regulatory restrictions hinder exchanges like Coinbase and Kraken from building robust derivatives markets. It is no wonder that Coinbase launched an offshore cryptocurrency derivatives exchange a few months ago.

However, almost all trading volume of perpetual contracts occurs on centralized exchanges. To understand the dominance of centralized exchange trading volume over decentralized exchanges, consider that the trading volume of decentralized spot exchanges typically only accounts for 10-20% of centralized exchanges. In fact, Uniswap has had higher monthly trading volume than Coinbase for four consecutive months this year. In comparison, the adoption rate of perpetual contracts on decentralized exchanges is only 1-3%.

The main reason for this gap between the two verticals may be that creating a decentralized exchange for perpetual contracts that is comparable to centralized exchanges is more difficult. Relatively speaking, creating an acceptable decentralized spot exchange is relatively simple (similar to a variant of x*y=k), but achieving the same level for perpetual contracts is much more challenging, as it involves multiple complex components such as managing margin requirements, cross margin, funding rates, leverage ratios, price oracles, insurance funds, and so on.

In addition, perpetual contracts are a lucrative source of profit for centralized exchanges, resulting in intense competition. Decentralized exchanges not only need to catch up with centralized exchanges, but also keep up with the innovation and improvement of perpetual contracts by multiple centralized entities.

However, the rewards are also significant. All exchanges in the market follow the power law distribution, where dominant exchanges occupy the majority market share while a few exchanges occupy almost all market share. This is mainly due to network effects (liquidity generates liquidity) and economies of scale (larger exchanges can reinvest more efficiently).

For centralized exchanges, leading exchanges typically account for 60-80% of the total trading volume of perpetual contracts. Historically, BitMex dominated the trading volume of perpetual contracts as they were the first to invent this product. However, since 2019, exchanges such as OKX, Binance, and ByBit have engaged in fierce competition. Since 2021, the industry has gradually consolidated, especially after the collapse of FTX in 2022. Currently, Binance occupies approximately 60% of the total trading volume of perpetual contracts. The top three exchanges account for about 90% of the market share.

We believe that decentralized derivative exchanges will also exhibit a similar market structure, where leading exchanges will occupy the majority of the market share. If this assumption holds true, the potential value of the market winner will exceed $25 billion.

Next, we will explain how the valuation of a hypothetical leading decentralized exchange can grow from $500 million to over $15 billion if it can execute correctly. If the trading volume of decentralized exchanges approaches or even surpasses that of centralized exchanges, these estimates may prove to be very conservative.

How can decentralized perpetual contracts win?

To validate our argument, we need to understand why traders prefer decentralized exchanges (DEXs) over centralized exchanges (CEXs). Below, we list some key factors that traders typically prioritize when choosing an exchange, whether it is DEX or CEX. While this list does not encompass all factors, it is a good starting point to evaluate how DEXs can win.

While all factors are important, liquidity is the most critical aspect of an exchange. Without liquidity, the exchange has no value for buyers, sellers, or market makers. Most exchanges stagnate or fail due to a lack of liquidity.

All other factors can be seen as improving the liquidity of the exchange. For example, cross-margin functionality significantly reduces the capital cost for market makers, helping to improve liquidity. Robust infrastructure allows professional market makers to manage risks when providing buy and sell quotes. Traders also prefer exchanges with superior performance and flexibility, as well as security mechanisms to handle black swan events.

Decentralized perpetual exchanges typically try to win by promoting non-custodial/KYC, while offering token rewards and negligible transaction fees. dYdX successfully utilized this strategy in 2021, quickly gaining trading volume and users, establishing itself as a top-tier decentralized trading venue. With the momentum driven by dYdX’s rise, new exchanges such as ApeX, Level Finance, and Kwenta have adopted similar strategies.

However, this inevitably led traders to find ways to obtain token rewards through fake trades. Most traders stop this behavior once the incentive program ends. Additionally, these traders often do not add substantial liquidity to the exchange, as they typically take on minimal market risk and only trade among themselves (or with other “farmers”).

These case studies indicate that factors such as non-custody/no KYC alone are not enough to attract substantial trading volume from centralized exchanges. Therefore, decentralized exchanges should carefully consider incentive programs, as they are useful supplements to drive liquidity but are less effective in attracting organic traffic.

DEXs may also not outperform CEXs in terms of performance. In the vast majority of cases, DEXs consistently lag behind CEXs in terms of latency, throughput, completion, etc., as they operate on centralized servers. Although DEXs may theoretically be more resilient during black swan events.

On the contrary, we believe that perpetual contract DEXs will gain penetration in areas where CEXs cannot compete, similar to how Uniswap and other spot DEXs have achieved prominence. From the list above, we have listed some examples of value propositions that only DEXs can provide:

Composability: By on-chaining part or all of the DEX infrastructure, other DeFi projects can connect to the perpetual contract DEX, creating new components. This has already happened on some larger perpetual contract DEXs, such as GMX and Synthetix. For example, multiple projects on Arbitrum are integrated with GMX’s liquidity pool (GLP) or its perpetual contract exchange (such as Rage Trade, Rysk, etc.). Another example is Lyra utilizing Synthetix’s perpetual contract engine to create a market-making repository for hedging options.

We believe composability is the primary way for decentralized perpetual contract exchanges to win. An ecosystem built by proactive entrepreneurs and interacting with each other in a composable and permissionless DeFi system will gradually but inevitably surpass an internal team of a centralized exchange.

Decentralization: Decentralization is not just a virtue; it also improves the unit economics of DEXs relative to CEXs. DEXs outsource many critical functions, improving cost structures and allowing more capital for reinvestment. For example, decentralized exchanges do not need to invest in custody of assets or hire lawyers to determine which assets to list. Settlement of trades is usually outsourced to the blockchain layer. Moreover, in extreme cases, decentralized projects also do not need to geographically block users or perform KYC, although this may only be a temporary advantage due to regulatory inertia.

The decentralized distribution of tokens incentivizes grassroots communities to market and build the project. Members of GMX’s “Blueberry Club” and dYdX’s “Hedgies” actively promote their respective platforms on Twitter. With token ownership, members also help establish dashboards, analytics tools, and even build other projects on perpetual contract DEXs.

Other considerations:

Transparency: DEXs can provide more than just non-custodial user assets. In a CLOB-style DEX, we can ideally see all trades of all parties involved – gaining order book insights that CEXs do not provide.

Permissionless asset listing: Some CEXs do not list certain trading pairs due to conflicts of interest or regulatory reasons. In contrast, DEXs offer the potential to list any suitable asset with sufficient liquidity. These DEXs can even list assets beyond the realm of cryptocurrencies, such as commodities and forex.

Liquidity: We believe that the main reason GMX organically gained market share and retail flow is because it provided ample 24/7 liquidity at the prevailing market price, with no slippage. At the time, few other perpetual contract DEXs were able to offer such a service. This further reinforces our argument that liquidity is the primary factor determining the success of an exchange.

In summary, DEXs are likely to succeed by adopting strategies and operating models that CEXs cannot replicate in their structure.

Overview of decentralized perpetual contract exchange design

There are three main designs for decentralized exchanges (DEXs):

1. Centralized Limit Order Book (CLOB) – an order book that aggregates all buy and sell orders for a particular asset, with trades occurring when buy and sell prices match.

2. Multi-asset pool – a pool that includes multiple assets (including cryptocurrencies and stablecoins) to serve as the counterparty for trades.

3. Single-asset pool – a pool that includes only one asset (typically a stablecoin like USDC) to serve as the counterparty for trades.

The Centralized Limit Order Book is relatively straightforward. It is a proven model of traditional exchanges operated by centralized entities. The main challenge in porting this model to the blockchain lies in the higher computation, bandwidth, and storage costs of the blockchain. Currently, most teams manage the computationally expensive parts off-chain.

The other two models are native to cryptocurrencies and emerged due to immature on-chain markets and the inherent high transaction costs of blockchain. Projects using these two models rely on asset pools and price oracles to execute trades. While this is a simple idea, it also brings a whole set of other challenges.

Understanding asset pool design in depth

Because asset pools are a relatively new and unproven design, we will spend more time discussing the pros and cons of pool design.

Does the house always win?

In pool design, the profitability of traders often comes at the expense of the cost of providing liquidity, and vice versa. Therefore, their sustainability and success depend on the argument that “the house always wins” being validated.

To evaluate the merits of this argument, we can first look at the history of these cryptographic products themselves. The GMX dashboard shows that traders on the platform have been consistently losing money since August 2021. However, traders can also make sustained profits when the price trend is rising. Similarly, Synthetix’s Perp v2 shows cumulative net trader losses, but there have also been periods of positive returns.

However, the sample size of this data is limited. We can further refer to statistical data from traditional markets to validate this assumption. Perhaps the closest comparison to cryptographic perpetual contracts is CFDs (Contracts for Difference), as they are 1) financial instruments derived from underlying assets, 2) allow for extremely high leverage (some as high as 500x!), and 3) products targeting retail investors.

This data supports this view. In the United States, companies typically disclose that about 70% of client accounts lose money each quarter. In Europe, the European Securities and Markets Authority (ESMA) requires regulated brokers to report the profitability rate of retail clients. Among all brokers, about 74% of clients are incurring losses. In France, a study found that the majority of retail investors (89%) suffered trading losses over a four-year period. Similarly, a report from Spain found that 75-85% of clients experienced losses.

Considering that most cryptographic perpetual contracts allow for relatively high leverage on asset classes with higher volatility, it is reasonable to assume that similar statistical data applies to decentralized exchanges (DEXs).

Defeating the house

It should be noted that the view that “the house always wins” faces the primary risks of adverse selection and harmful flow.

Adverse selection refers to exchanges attracting only smart traders. In extreme cases, losing traders no longer trade on the exchange. If all losing traders are lost (their funds exhausted) without new uninformed traders joining the platform, this situation may occur. This poses a greater risk for market laggards. If there are no new traders joining the platform, liquidity providers on DEXs face the risk of becoming opponents to smart traders who only trade with liquidity providers when it is profitable.

Related to the above situation is the risk of harmful flow. Harmful flow refers to orders that profit from short-term trading due to information asymmetry. For pool-based DEX designs, the most common source of harmful flow is traders running price oracles on the frontend. For example, if a trader sees the price of ETH on Coinbase suddenly rise from $1850 to $1900, the trader may attempt to trade on a oracle-dependent DEX at the old price of $1850, waiting for the oracle to update the price of ETH to $1900, and then sell for a profit. Although new pull-based oracle designs largely solve this problem, there may still be vulnerabilities.

Harmful liquidity can also come from many other sources. Savvy traders can attempt to profit from perp positions by buying large positions on perps DEX and then manipulating the price of the underlying asset. Alternatively, traders with good relationships with multiple exchanges can also aggregate the likelihood of short-term price fluctuations and use DEX perps as a place to profit.

Long-term Crypto Phenomenon

Another factor in the design of mining pool DEX is what we call the “long-term crypto” phenomenon – most cryptocurrency participants tend to be net long. Single-coin pools priced in USD stablecoin USDC are particularly vulnerable to this phenomenon, as liquidity providers (LPs) bear the risk of the other side of the trade (net short). So in a bull market with an upward trend, LPs are likely to suffer significant losses. This can trigger a “death spiral” effect, where LPs withdraw liquidity, reducing available exchange liquidity and preventing users from trading on the platform, which in turn triggers LPs to withdraw liquidity, thus creating a cycle. In contrast, multi-coin pools are easier to manage because the pool itself is naturally in a net long position.

The key to managing this issue is to incentivize traders to take on the other side of the trade risk and/or increase the cost of crowded trades. For example, Synthetix’s dynamic funding rate helps significantly mitigate this risk.

Determination

Pool-based DEXes do have their advantages in the perpetual contract trading field, providing attractive features for both the demand and supply sides of exchanges. On the supply side, they somewhat balance the competitive environment, effectively allowing liquidity providers to outsource price discovery to other markets. Both retail and institutional liquidity providers offer the same quotes to traders. On the demand side, they provide competitive price execution for traders.

However, the ultimate value of these exchanges may be limited as price discovery always occurs on other trading platforms. It is almost impractical for pool-based exchanges to capture more than 50% market share. Additionally, their growth is limited by the support of price oracles and the capital efficiency of liquidity providers.

Therefore, although they play an important role as alternative trading venues and have strong growth potential, we believe that leading derivatives exchanges will be exchanges that can achieve endogenous price discovery, most likely in the form of central limit order book (CLOB) style exchanges. CLOBs provide traders with the best capital efficiency and the most effective way to express preferences. Their appeal lies in the current limitations of blockchain infrastructure, but we expect several innovations to improve CLOB DEXs in the near future. In the meantime, hybrid CLOBs – where order matching is done off-chain but settlement is done on-chain – are a suitable compromise.

Current Status

Compared to centralized exchanges (CEXs), the current decentralized exchange (DEX) market structure is still immature and scattered. dYdX is usually ahead in terms of trading volume, as it is a pioneer in decentralized perpetual contract exchanges and has attracted multiple market makers. However, SNX also has high trading volume in multiple cycles, with recent peaks coinciding with the launch of trading incentives. GMX, ranked third in weekly trading volume, has been steadily growing with strong community support.

Weekly token trading volume Source: Token Terminal

Value accumulation is another matter. GMX and SNX token holders can participate in the growth of their respective exchanges by staking tokens and earning a portion of platform fees. On the other hand, although dYdX generates revenue through fees, token holders are currently not involved.

Weekly fees Source: Token Terminal

Conclusion

We reiterate our belief that the decentralized derivatives trading sector, especially decentralized perpetual contracts, will continue to grow in the coming cycles. In the second part, we will examine various operational and upcoming decentralized exchanges based on this report, and delve into three particularly exciting upgrade designs: GMX v2, Synthetix v3, and dYdX v4.

Crypto Derivatives LianGuairt 1 Perpetual Contract