The Road to DeFi Derivatives
1.Basic modules of modern finance
A few months ago, in his article “Re-understanding DeFi from Eight Key Perspectives and Logics”, Dr. Chuanwei Zou sorted out the six functional modules in the modern financial system and their corresponding relationships with the DeFi system. Among the six basic modules, managing risk is sitting in the core of the entire financial system, and it is the more sophisticated part of finance. It needs to be pointed out that the risk management includes all the activities in the financial industry dealing with risks, including passive risk management that mitigates business risks (usually middle office’ responsibility of Wall Street investment banks and asset management companies) as well as actively dealing with risks to acquire some risk exposures in order to make profits (usually a front office job of the financial companies). From this perspective, the Wall Street business is all about dealing with risks. The so-called sell-side and buy-side of Wall Street are sitting on the two sides of the dealing-with-risk coin.
The most important tool invented by the financial industry to deal with risks is financial derivatives. Considering risk dealing is in the core of modern financial system, it is fair to say the derivative business is the jewel in the crown of modern finance. The essence of a financial derivative is to extract certain risk factor from the financial market (e.g. the equity market, some interest rate, some commodity price, the default probability of a company, some volatility, etc) and link it to a contract’s cashflows such that the contract holders precisely acquire the risk factors they wanted. As an example, the price of a corporate bond is usually determined by the benchmark interest rate in the capital market (i.e. the risk-free interest rate) and the company’s default probability (precisely, the default intensity curve). And a credit default swap (CDS) on a corporate bond extracts the single risk factor of default so that people can trade the underlying company’s credit precisely.
2.The structure of traditional derivatives market
In the traditional financial market, the derivatives market consists of two parts: exchange-traded and OTC derivatives. The former selects the most common and representative risk factors in the market and designs standard derivative contracts representing them so that such risk factors can be traded on the exchange. Such trading is usually carried out as continuous bidding on the orderbook for price discovery and matching between buyers and sellers. The latter is to satisfy customers’ specific financial purposes. Generally speaking, the former has large trading volumes per single product and thus great liquidity, but it may not exactly match with clients’ specific financial purposes. Users adopting such derivatives to deal with risks (whether active speculation or passive hedging) may have the issue that their positions do not exactly match with their real financial purposes. Such “error” is generally called basis risk. OTC derivatives are generally tailored to the needs of their clients by the trading desk of investment banks (known as the “sell-side” on Wall Street). They can generally meet customers’ financial goals more accurately, but they are relatively expensive (the derivative “seller” usually add a premium to the fair price, which is how the “sell-side” makes profit), and it is usually not quite liquid as its non-standard nature. A rough analogy can compare exchange-traded standard derivatives and OTC derivatives as wholesale and retailing sale of risks. The former has a large transaction volume on each single product and meets common needs, while the latter divides, transforms, and combines the former to meet customers’ specific needs in different scenarios.
At the moment, DeFi is growing rapidly in the crypto world. In the phrase of DeFi, Decentralized Finance, “decentralized” refers to the method and means, while “finance” is the goal. DeFi is committed to solving the same problems as traditional finance. Therefore, derivatives will also be the jewel in the crown of the DeFi world.
3.DeFi’s early imitations of traditional finance
It is straightforward for the early attempts of DeFi derivative solutions to imitate how the traditional derivative market works. That is, they simply implement orderbook-based matching engines for derivatives in a blockchain way. However, due to the performance constraints of blockchains (e.g. ETH), running an orderbook-based matching engine is mission impossible for most of the blockchains, e.g. Ethereum. Therefore, the early pathfinders had to make some “compromises”:
(1) Run the most computation-intensive part (the matching engine) off-chain, i.e. on a centralized server, and only write the matching results into the blockchain. This is not holy DeFi, but a semi-centralized solution. Representative cases of this path are dydx, MCDEX, and DerivaDEX (not online yet).
(2) Run the matching engine on layer2, and only write the matching results into the blockchain of layer1. A representative case is Injective (not online yet).
(3) Abandon the “low-performance” Ethereum and adopt a “high-performance” blockchain with a TPS sufficient to support the orderbook-based matching engine. A representative case is Serum. Serum is deployed on the Solana blockchain. However, since it is not part of the ETH ecosystem, it currently has limited interaction with the mainstream DeFi world.
DeFi is built on a brand-new technical infrastructure, its implementation of derivatives will be different from traditional finance. The DeFi world will take its own path to derivatives.
4.DeFi’s innovation
Meanwhile in the field of stablecoins, another sub-field of DeFi, MakerDAO has achieved great success in synthesizing U.S. dollars with collateralization. The DeFi world witnessed the first USD stablecoin that is truly native to the blockchain. It is DAI as we know. MakerDAO’s approach inspired DeFi developers to implement “derivatives” in a similar way. This idea is actually quite straightforward: since the US dollar can be anchored with over-collateralization, the same thing can be done to other types of assets. After all, the US dollar is just one special type of assets. So the Haven team made some adjustments to their USD stablecoin project. Instead of anchoring USD, they issue tokens to anchor arbitrary assets, such as BTC. This was the Synthetix project as people now know. Since the price of SNX itself and the price of the anchored object are both fluctuating greatly (SNX itself is much more volatile than MakerDAO’s pledge asset ETH), Synthetix requires a stringent requirement for the pledge SNX used to generate synthetic assets — a pledge rate of 750%. Nevertheless, Synthetix’s approach has the following problems:
(1)Limited leverage: The 750% pledge rate restricts the overall leverage of participating traders; in fact, the 750% pledge rate makes it impossible for Synthetix’s total derivatives volume (total notional) to exceed 0.13 times the total market value of SNX;
(2)Synthetix forces users to accept SNX as a “in-house chip”, which is not in line with the “open finance” concept of the DeFi world;
(3)Synthetix’s transaction execution process is extremely complicated (especially Synthetix’s special overall debt system for all borrowers)
In addition to inspiring new ideas, Synthetix also demonstrated the significance of composability in the DeFi world: Synthetix synthetic assets are so valued by the DeFi world largely because the synthetic assets by Synthetix can be played with like lego blocks, i.e. to be used by other DeFi projects as basic functional modules to achieve their own financial purposes. Synthetix’s composability is achieved through tokenization of the underlying assets. Whether it is BTC in the crypto world or gold in traditional finance, the underlying is tokenized into ERC20 in the Synthetix system, namely sBTC or sXAU. However, while tokenization is essential to the DeFi ecosystem, Synthetix has tokenized the wrong objects. It is the position that should be toknized, not the underlyer.
At the same time, the DeFi world has also made some attempts on the OTC derivatives. As an example, UMA provides an protocol that facilitates the counterparties of an OTC derivative into a smart contract to implement the derivative. However, such a protocol requires a derivative’s buyer and seller first match up themselves and then use the UMA protocol to enter the contract. In the early stage of DeFi, due to the lack of readily available “derivatives sellers”, it is difficult for users to match up with their counterparties in the UMA system. Therefore, the use of UMA is relatively limited at this stage.
5.Liquidity pool — a new species in the DeFi world
While the DeFi world is exploring derivatives solutions, some revolutionary developments in spot trading have brought the entire DeFi world to a new stage. Uniswap implemented the so-called Constant-Product Market Maker and thus enabled the exchange of tokens (spot trading) based on liquidity pools. In a very short time, a number of *swaps based on liquidity pools emerged out. Such automatic market maker (AMM) trading paradigm has become dominating the spot trading of DeFi. It has also opened up new ideas for DeFi derivatives trading.
With the new wave of liquidity pool-based trading paradigm sweeping the DeFi world, a new DeFi derivatives route has emerged. Based on liquidity pools, smart contracts can automatically make markets to satisfy the demands of derivative. But unlike the constant product market maker adopted by Uniswap, derivatives must rely on the price of the underlying asset — this is by derivatives’ definition. In other words, derivatives solutions must rely on oracle price feeds.
A representative of the liquidity pool solutions is Deri, which is a decentralized protocol for people to trade derivatives. Like Uniswap, the liquidity pools of Deri protocol play the roles of counterparties of the traders. And its core trading mechanism is completely implemented on-chain. Deri will support perpetual contracts in the first step, and in the second step plans to support futures contracts with expiration. It is also developing solutions for option contracts.
Passive counterparties in the financial market always face the risk of loss when trading with active traders with information advantages. In traditional financial markets, this is the core problem that market-makers need to solve. In the DeFi world, such risks will not disappear simply because of the technology changes. Under Uniswap’s constant product market maker system, the so-called impermanent loss is the very risk due to LPs’ information disadvantages. Uniswap has not made any protection or remedy for the impermanent losses suffered by LPs (except for awarding UNI tokens to four liquidity pools’ LPs). While the impermanence loss issue is not too serious on Uniwap, it has to be taken care of in derivatives trading. To solve this issue, Deri introduced a unique funding fee mechanism to attract arbitrageurs to participate in the transaction. Under the Deri mechanism, arbitrageurs become the protectors of LPs (whereas under the Uniswap system, LP’s impermanence losses are actually arbitrageurs’ profits).
Another project called Hegic for options trading has been launched recently. It is designed in a likewise way to make liquidity pools to play the role of the counterparties of option buyers. The popularity of the Hegic project shows the great prospects of the liquidity pool paradigm and its feasibility of becoming the ultimate solution for DeFi derivatives. However, due to the rush of the project launch and the team’s incomplete understanding of options, Hegic looks more like an early experiments for DeFi option solutions. The major problems with Hegic are:
(1) It’s quite risky for the LPs as there is no protection for LP’s impermanent loss. From a financial perspective, the pools are running “naked” (unhedged).
(2) The fixed option price (premium) makes it impossible to catch up with the rapidly changing option market;
(3) While there is a certain probability that the deltas of call and put buyers cancel each other out to reduce the delta risk of the liquidity pool, both call and put buyers are long vega, which means that the liquidity pool is always short vega. Considering the wild volatility of the crypto market, maintaining a constant short vega position is like committing suicide.
6.Summary
2020 was the emerging year of DeFi. However, most of the existing DeFi projects belong to the easy part of finance. That is, they do not deal with complicated risks. As the DeFi movement continues to advance, the decentralized revolution will sweep the entire financial world. That is, DeFi has to tackle the sophisticated part of finance, where you have to dance with risks. DeFi has evolved into a game of math, finance and computer science. In the upcoming stage, any developer/team would find it very risky if missing any of the three as it may lay a fatal risk for their DeFi project. However, it is the challenge that makes the game exciting. In 2021, more elite teams will gather in the DeFi world and grow wildly on the new mainland. This will lead us to a new financial world.
