Decentralized Derivatives Track Analysis

Introduction:

In the world of cryptocurrency, derivatives have always played a crucial role, providing investors with tools to manage risks and engage in arbitrage. However, centralized exchanges (CEX) have been plagued by issues such as lack of transparency, regulatory concerns, users’ inability to fully control their assets, and exchange malpractice. The FTX incident last year serves as a prime example, with SBF misappropriating user funds, resulting in a shortfall of approximately $8 billion and causing significant losses for millions of users, thus impacting the entire industry. This has prompted a profound reconsideration of how the crypto market operates, leading to a gradual shift towards decentralized exchanges (DEX) and decentralized derivatives exchanges. Currently, DEX represents only 10% of the trading volume compared to CEX, and the decentralized derivatives market accounts for less than 2% of the total volume, indicating immense potential for growth. Following the FTX incident and a recent series of regulatory concerns, more users and funds are flowing towards DEX, providing significant development opportunities for decentralized derivatives markets. While there is currently no leading product in the decentralized derivatives market like Uniswap in the DEX space, an increasing number of protocols are entering this highly competitive market.

Development of Cryptocurrency Derivatives Exchanges:

Importance of Derivatives:

Why Cryptocurrencies Need Derivatives:

1. Risk Management: The cryptocurrency market is highly volatile, offering both high-profit opportunities and significant risks. Derivatives, such as futures and options, provide investors with tools to hedge these risks.
2. Speculation and Arbitrage: The high volatility in the market creates ample opportunities for speculators. Derivatives, especially leveraged products, allow investors to capitalize on potential high returns with a smaller initial investment. Additionally, price disparities between derivatives and spot markets create arbitrage opportunities.
3. High Returns: Derivatives, particularly high-leverage products, can provide significant returns, often amplified by leverage. However, while these products enhance returns, they also expose users to substantial losses. In the cryptocurrency market, derivative users have an average lifecycle of around three months. This is mainly due to the use of high leverage, inadequate position management, exchange malpractice, and many users lacking sufficient technical skills to analyze the market, leading to liquidation events. These issues are mitigated to some extent in DEXs, where practices like exchange malpractice are eliminated. DEXs also provide unique tools and services, such as intelligent fee adjustment, hedge arbitrage, and insurance, to help users better manage risks and avoid liquidations.
4. Market Maturity: The presence of a thriving derivative market reflects the maturity of a market. A robust derivatives market attracts investors seeking sophisticated investment strategies and risk management tools.
5. 24/7 Market: The cryptocurrency derivatives market operates 24/7, unrestricted by geographical or time limitations. This is advantageous for users who require real-time trading capabilities.

Why Decentralized Derivatives are Needed:

1. Greater Transparency: Decentralized derivatives utilize transparent smart contracts, and all transaction records are stored on the blockchain, accessible to anyone. This transparency helps improve market efficiency, prevent fraudulent activities, and enhance user trust.
2. User Control of Assets: A key feature of decentralized derivatives is that users have complete control over their assets. In centralized exchanges, users must deposit their assets into the exchange, exposing them to risks such as asset freezing, theft, or exchange insolvency. However, in decentralized derivatives markets, users’ assets remain in their own wallets, and only the users themselves can control those assets.
3. Improved Market Access: Decentralized derivatives platforms typically do not require complex registration processes or identity verification, allowing people from anywhere in the world to participate.
4. Enhanced Resistance to Censorship and Privacy Protection: With the emergence of regulatory issues, decentralized derivatives protocols are designed to have stronger resistance to censorship. Additionally, decentralized derivatives do not require KYC, protecting user privacy.
5. On-Chain Composability: For example, developers can create a new financial product that interacts with multiple different derivatives protocols, offering users an entirely new investment strategy. Alternatively, a decentralized lending protocol can be integrated with a derivatives protocol, allowing users to use their derivatives as collateral. This composability makes the decentralized derivatives ecosystem highly flexible and innovative, with the potential to drive greater prosperity and activity in the entire cryptocurrency market.

Challenges of Decentralized Derivatives:

1. Market Liquidity: Compared to centralized markets, decentralized derivatives markets may have lower liquidity. This can result in larger trading slippage and increased transaction costs.
2. User-Friendliness: Centralized exchanges (CEX) offer a better user experience and a lower learning curve, while decentralized exchanges (DEX) require users to learn new trading rules and processes, which undoubtedly increases the learning cost and entry barriers for users. Additionally, DEX may have a less diverse product offering compared to CEX.
3. Oracle Risks: Decentralized derivatives heavily rely on oracles to provide price information for off-chain assets. However, oracles can be manipulated or subject to failure, leading to incorrect price information being input into smart contracts and potentially causing unfair trading or other issues.

Operational Mechanisms of Decentralized Derivatives:

1. AMM Approach: The AMM approach, based on the AMM model X*Y=K used in Uniswap, has been modified (e.g., vAMM, sAMM) to form a pool or virtual pool of funds. Traders interact with the assets in the pool to take long or short positions, which may lead to “impermanent loss” issues.
2. Order Book Approach: The order book model involves market makers providing liquidity through offline matching and online settlement. The current contract trading price is determined by the price on the order book, which is priced by market makers. Hence, market makers become a crucial core of order book-based trading platforms, resembling traditional centralized exchanges.
3. Synthetic Asset Approach: The trading model involves users generating sUSD through collateralization based on a collateralization rate, and then exchanging sUSD for any synthetic asset within the system. Users can take long positions using sTokens or short positions using iTokens. This approach relies on reliable oracles to provide prices for external assets.
4. P2POOL Approach: This is a relatively novel model where liquidity providers act as counterparties to the trades. They profit by providing funds and collecting transaction fees. One advantage of this approach is that it can provide continuous liquidity and reduce transaction costs.

Decentralized Derivative Market Data:

Decentralized derivative exchanges, in comparison to spot DEXs, still represent less than 2% of the market share held by centralized exchanges (CEXs), highlighting their tremendous potential.

Decentralized Derivative Market Share (by type)

Future Development and Trends:

1. Building Proprietary Chains: To achieve more efficient trading and greater decentralization, future decentralized derivative exchanges may consider building their own chains. This will significantly improve trading fluidity, reduce transaction costs, and provide greater control over trading rules. Additionally, it can offer better privacy protection, stronger security, and higher customization possibilities. While it requires substantial technological investment, it will make exchanges more independent and flexible in the long run.
2. Multi-Product and Multi-Mechanism: Decentralized derivative exchanges need to offer a broader range of products and services to cater to different user needs. This may include a variety of derivative products, more trading pairs, additional liquidity mining mechanisms, and a wider range of financial instruments. Through continuous innovation and improvement, exchanges can meet broader market demands, attract more users, and enhance their market competitiveness.
3. Cross-Chain Compatibility: With the decentralization of the cryptocurrency market, cross-chain compatibility will become an important feature of decentralized derivative exchanges. By supporting cross-chain transactions, exchanges can connect to more blockchain networks, provide broader trading opportunities, and attract more liquidity.
4. Improved User Experience: Decentralized derivative exchanges need to continuously improve their user experience to attract more users and maintain user loyalty. This may involve more intuitive user interfaces, simplified trading processes, detailed user guides, and better customer service. For non-technical users, user-friendly trading platforms can significantly lower the barriers to participation in decentralized finance.

Conclusion:

The decentralized derivative market is gradually gaining attention due to its unique advantages such as high transparency, full asset control, censorship resistance, privacy protection, and on-chain composability. However, there is still a significant gap in trading volume between DEX and CEX, with DEX accounting for only 10% of CEX’s trading volume, and the market share of decentralized derivatives being less than 2%, indicating enormous potential. Nevertheless, with more users and funds flowing into DEX, we firmly believe that the decentralized derivative market will mature and play a more significant role in the cryptocurrency market. To achieve this, decentralized derivative exchanges need to be driven by innovation, develop diversified mechanisms and products, support cross-chain transactions, and even establish proprietary chains to optimize trading processes and continually enhance the user experience. Only by doing so can we meet the growing demands of users and drive the continuous development of the decentralized derivative market.