Based on AMM perpetual contracts, options, and volatility trading products, how much development space is there in the future?
Original Author: GABE TRAMBLE
Original Translation: Deep Tide TechFlow
Introduction
For some, Automated Market Maker (AMM) is the only aspect of interest in decentralized exchanges (DEX). Due to factors such as low liquidity and dependence on traditional market makers, centralized exchanges often exclude these assets. Whether it's Uniswap, Curve, Balancer, or aggregators like MetaMask and 1inch, AMMs have facilitated trillions of dollars in value traded since their introduction a few years ago. The permissionless design of DEX makes it an ideal platform for trading low liquidity or long-tail assets, as anyone can create a market for new assets. In contrast to traditional CEX, which requires manual integration of assets, AMMs can seamlessly deploy and trade any ERC-20 token as long as there is liquidity provided by someone. This is because AMMs allow anyone to deposit assets and become a market maker without the need for institutional entities as in traditional finance (TradFi). Market makers increase liquidity on exchanges by providing buy and sell orders to ensure users can execute trades without the presence of other users. They make money by taking advantage of the price difference between buy and sell prices.
However, most spot AMMs are very basic and typically only support buy and sell orders. Some spot AMMs and aggregators offer advanced features such as limit orders and deep liquidity (liquidity sufficient for large entities to trade). However, they still cannot translate their liquidity into other trading primitives.
In the product world, it is often said that a product needs 10 times improvement to replace existing products and gain significant adoption. The introduction of DEXes like Uniswap solves the liquidity problem by allowing users to create markets for any ERC-20 at lightning speed.
DEXes like Uniswap and Curve have been battle-tested for a sufficient amount of time and can be used as primitives for other products.
Similar to the DEX Spot Market, perpetual futures (Perps), options, and other trading products also face fierce competition and are still dominated by CEX in terms of trading volume. Despite the dominance of CEX, there is still tremendous growth potential for perpetual futures, options, and other trading products by leveraging the composability of DeFi, the stacking of DeFi "building blocks," or applications that can be mutually constructed.
Most on-chain perpetual futures and derivatives have only a few assets, use oracles, and are easily affected by liquidity issues. Without sufficient liquidity, derivative exchanges cannot operate and attract more users, which is called the chicken and egg problem. To achieve this goal, new protocols are leveraging centralized and constant function AMM liquidity to drive new trading products (leverage, perpetual futures, and options). In short, the protocol uses AMMs like Uniswap as liquidity primitives to create new trading products.
Constant Function AMM: Liquidity is typically distributed infinitely across the entire price range (Uniswap v2, Balancer).
Concentrated Liquidity AMM: Liquidity is concentrated within the price range (Uniswap v3).
The Uniswap Moment for Perpetual Futures and Options
The killer use case for AMM-driven trading products is the ability to create perpetual futures (Perps), hybrid options, and other volatility markets for assets with insufficient liquidity and newly deployed assets. During its FOMO period, $PEPE's market cap skyrocketed to billions of dollars in just a few weeks. During this highly volatile period, traders repeatedly asked, "Where can I go long on $PEPE?"
Despite the significant increase in PEPE's popularity, attracting billions of dollars in trading volume, initially only the spot market could trade the asset. Several weeks later, some exchanges began to support perpetual futures (Perps) trading, which has been the sole trading source even until now. Even in some exchanges that support $PEPE trading, many traders believe that there are issues with liquidation and settlement, which is a core problem in the design of perpetual trading exchanges. Through AMM-driven volatility products and derivatives, LPs have the opportunity to marketize options and perpetual futures at the token issuance stage, similar to Uniswap.
There is a significant speculative demand for encrypted assets, especially in terms of leverage. In addition to leverage, these products provide hedge LPs with good tools for their positions in assets.
Perpetual Trading Products
Many on-chain perpetual contracts rely on oracles, which can be easily manipulated for long-tail assets. Oracles transform off-chain data into on-chain data that protocols can use, typically for price feeds. Have you ever wondered why decentralized exchanges (DEXs) for perpetuals only support a few assets? Most on-chain perps and options platforms only offer a small number of assets aimed at achieving deep liquidity and utilize external oracles as pricing mechanisms. Liquidation risk is also a significant issue as managing liquidations relies on accurate oracles and ensuring trades can be liquidated promptly to meet collateral requirements. In other words, liquidations need to occur seamlessly to ensure there is enough collateral to cover the trades. Through trading products driven by Concentrated Liquidity AMM (CLAMM), oracles and liquidation risks are typically eliminated as liquidity is borrowed from a predefined LP range.
By adopting this approach, a trader's risk is also predefined and limited within the parameter range set by the exchange protocol for closing positions. Many protocols that enable AMM LPs use a perpetual mechanism to determine the duration of trades, allowing the trade duration to extend as long as the fees to keep the position open are paid.
AMM and LP Fees
Centralized Liquidity Automated Market Makers (CLAMM) and Constant Function Automated Market Makers (CFAMM) constitute the two-sided market involving Liquidity Providers (LPs) and traders. For traders, the experience with AMM products is mostly similar. On the contrary, many exchanges strive to optimize the experience of providing liquidity as this often results in losses. In many cases, LPs require additional incentives to be profitable.
Many liquidity providers add liquidity to AMMs based on the assumption that they will receive enough fees to offset impermanent loss (IL). It is also worth noting that not all LPs adopt a HODL strategy. One core improvement of the Concentrated AMM liquidity derivatives model is that LPs now receive compensation not only through trading fees but also through volatility. This innovation introduces a new dimension to the return on providing liquidity.
For some AMM-driven derivatives like Uniswap V3 and Panoptic (Panoptic Option Sellers), LPs can generate fees when they are within a range and commission fees when they are outside the range. When LP tokens surpass the range, they can be used for the protocol's volatility product, whether it is leveraged trading, margin trading, or options trading.
AMM LP-Driven Trading Products - How Do They Work?
Currently, the protocol for trading derivatives driven by AMM follows a simple assumption, which is to provide LP similar to selling put options in CLAMM. In other words, the return structure provided by liquidity providers is mathematically similar to selling put contracts. Perpetual and volatility trading protocols can be built around this concept to create trading derivatives and strategies, including leverage, perpetual futures, perpetual options, and other structured products.
Protocol Overview
Currently, there are several protocols aimed at trading using CFAMM and CLAMM liquidity. Some of these trading products include leverage and margin trading, options products, perpetual futures, etc. Although this concept is still novel, many developers have found opportunities to fill the liquidity and asset gaps of major assets and long tail assets in trading products. The table below shows the protocols, their liquidity AMMs, and the trading products they create:
Let's further explore the mechanisms and designs.
Perpetual Options Mechanism Design
Protocols like Panoptic and Smilee utilize centralized liquidity LP to support their trading products, including perpetual options and volatility trading. In a few protocols that utilize centralized liquidity from existing AMMs, each protocol presents slightly different architectures and implementations in building trading products.
At a high level, the protocol extracts centralized liquidity from AMMs like Uniswap v3 or its own AMM and allows traders to borrow these assets. Then, traders redeem the underlying LP tokens to obtain a single asset, simulating long or short positions limited to the range of centralized liquidity. Due to the nature of centralized liquidity positions, they always consist of 100% of one of the assets in a pair (e.g., USDC/ETH). As LPs expect to have 100% of a pair of assets in the liquidity pool, traders need to pay fees to borrow and redeem LP tokens to obtain one of the assets. Depending on their trading strategies, they can sell the redeemed tokens and convert them into directional bets.
Example with ETH Long Position
Take perpetual options as an example, assuming a trader wants to borrow a USDC/ETH LP token, where the price of ETH is $1000. The trader wants to go long on ETH, so they borrow the USDC/ETH LP token at a price lower than the current price, which is worth $1000 USDC. The value of the LP token is $1000 USDC because the current price has moved to the right of the range, causing the LP (option seller) providing liquidity to hold 100% USDC. The strike price for the option buyer can be seen as the midpoint of the LP range; in this example, we will use 900. Since the trader has a long position, they redeem the LP token worth $1000 USDC and exchange it for 1 ETH worth $1000 USDC. If the price of ETH rises to $1500, the option buyer can exercise the option by selling 1 ETH at a price of $1500 because the value of ETH now exceeds the value it was purchased for by the option buyer, allowing them to repay the borrower and earn an additional $500 profit. The option buyer only needs to repay $1000 USDC to the LP because it is the end point of the range they provided liquidity for.
The protocol usually abstracts away most of the complexity. Users may need to deposit collateral to pay for positional capital, choose the duration of the position (if included), the strike price, and the direction of the trade.
If the trade does not go as planned and the price of ETH drops to $800, which is beyond the opposite direction of the LP range, the borrower now owes 1 ETH instead of USDC. Since the borrower still owes 1 ETH, they need to find a way to acquire 1 ETH to repay the loan. If 1 ETH is worth $800, the borrower needs to use $800 USDC to purchase 1 ETH to settle the debt.
Decentralized exchanges (DEX) manage underlying assets for protocols like Panoptic to ensure LPs are rewarded. Unlike prepaying a premium to buy options, Panoptic requires users to have initial collateral in their wallet to pay for flow fees similar to funding rates. Collateral is required to ensure the payment of fees. The fee is determined based on the realized volatility and utilization rate of the underlying Uniswap pool to determine how much the option buyer should pay to the seller (LP). When a trader stops paying funding fees or the funding fees exceed their collateral, their position will be liquidated.
In both examples, the option seller continues to collect flow fees to maintain their position. This is a general overview related to Panoptic as each protocol has different approaches in managing liquidity, providing leverage, calculating collateral, premiums, and funding fees.
From a bird's-eye view, trading is bilateral, with LPs depositing their LP tokens into the protocol and receiving yield fees, while traders can open positions. LPs are incentivized to provide liquidity as they can earn rewards that surpass other methods. One core issue for LPs in AMMs is that their fees are not sufficient to offset the risks. Lastly, profitable traders can exercise their winning positions or continue to pay funding rates to LPs to keep the trade open.
Perpetual Futures Mechanism Design
For perpetual platforms like Limitless or InfinityPools, the mechanism is similar to perpetual options. However, users can deposit collateral that will be combined with borrowed LPs. The required collateral and leverage are determined based on the distance from the spot price. Like perpetual options products, if a trader borrows an LP token below the range, they can sell one of the underlying tokens, creating a directional leveraged bet. The design mechanism is very similar to the previous example, with the main difference being the collateral deposited by users to cover the maximum loss when the trade moves in the opposite direction. Both Limitless and InfinityPools claim to offer hundreds to thousands of leverage, depending on the distance between the range and the current price. If a trader incurs losses in a trade, the protocol will close their position and pay the collateral to the LP to complete the perpetual futures' short position.
Market Opportunities: Cryptocurrency Derivatives
Size of Traditional Financial Markets
According to Sifma Asset Management, the US stock market dominates globally, accounting for over 42.5% of the global market capitalization of $108.6 trillion in 2023, equivalent to $44 trillion.
Traditional Financial Derivatives Market
The nominal value of the derivatives market is estimated to exceed $1 quadrillion, although some believe this valuation may be inflated, according to Investopedia. This astronomical figure represents the upper limit of the nominal value of all derivative contracts.
There is a significant difference between the nominal value and the actual net value of derivatives, which as of 2021 were $600 trillion and $12.4 trillion, respectively.
In traditional finance, derivative trading is much larger in scale than spot trading. The same is true for the cryptocurrency market, but most trading volume occurs on centralized exchanges (CEX).
Bitmex is another centralized exchange that launched their perpetual (Perp) trading instrument in 2016, namely the perpetual XBTUSD leverage swap. Their new product allows users to trade Bitcoin (XBTUSD) with leverage of up to 100x. The contracts have no expiration date; longs pay shorts and vice versa. As the largest trading instrument in the cryptocurrency market, this product has expanded from centralized exchanges to various decentralized versions: DYDX, GMX, Synthetix, etc. The perpetual protocol facilitates hundreds of millions of dollars in trading volume daily and is a major derivative trading product in the cryptocurrency market today because of the high leverage it provides. This represents a significant shift from traditional finance, where options dominate the derivative market.
Cryptocurrency Spot Trading vs Perpetual Futures
In the first quarter of 2023, derivatives accounted for 74.8% of the total trading volume in the cryptocurrency market, amounting to $2.95 trillion. The market share of centralized cryptocurrency exchanges (CEX) and decentralized exchanges (DEX) for spot trading is 22.8% and 2.4%, respectively. It is worth noting that centralized cryptocurrency derivative exchanges like Binance, Upbit, and OKX dominate the market. According to Coingecko's 2023 report on cryptocurrency derivatives, although the trading volume of derivatives increased by 34.1% compared to the previous year, the growth rates for spot trading on CEX and DEX were 16.9% and 33.4%, respectively.
As of July 2023, 74% of cryptocurrency trading volume is conducted with leverage.
Innovative volatility trading platforms such as Panoptic, Infinity Pools, Smilee, etc., have driven industry growth by offering high leverage without the need for oracles, clearing, and even in some cases, eliminating prominent weaknesses such as managing oracles and clearing, thanks to the support of concentrated liquidity in AMM LP trading products.
Risks
While these products may be exciting, risks still exist. The most significant one is smart contract risk. As all AMM-LP trading products control LP tokens or require deposits, there is a potential smart contract risk if there are any vulnerabilities or errors.
Credit Liquidity Risk
In addition, there are also some problems with the economic design mechanism. The Gammaswap team conducted a feasibility study on Uniswap v3 and CLAMMs development, as they believe there is a "credit liquidity risk". This risk involves liquidity providers (LPs) being unable to pay long positions or vice versa, usually due to liquidation issues caused by excessive leverage. Due to concentrated liquidity, automatic market makers (AMMs) like Uniswap have areas or "ticks" with lower liquidity, and prices outside the range may result in excessive slippage, even for stable trading pairs. Gammaswap chooses to build on the constant function model, which they believe is a more powerful liquidity primitive.
In Uniswap v3, there may not be enough liquidity to satisfy LP earnings. Unlike traditional finance where the Federal Reserve can inject liquidity, there is no similar entity in the DeFi space. Additionally, there are no oracles traditionally used for liquidation, increasing the complexity of this problem.
Panoptic solves the credit liquidity risk problem by requiring pool creators to deposit small amounts of two tokens across the entire range, which traders cannot remove. The initial deposits ensure there is some liquidity in all price ranges.
Complexity and User Adoption
It has been proven that perpetual futures (Perps) are easier for cryptocurrency investors to understand. They operate through two mechanisms: long and short positions, which traders can open with a simple click of a button. In contrast, options and potential perpetual options introduce additional complexity, such as Greek letters, strike prices, and other traditional option knowledge, which may hinder user adoption. This is especially true for retail investors, who are often the earliest adopters of new trading tools. Additionally, introducing volatility trading adds complexity to the user experience. As the cryptocurrency space has already faced challenges with user adoption, some complex yet powerful products may struggle to gain widespread recognition due to their financial complexity.
Conclusion
Perpetual futures and options have found their place in the cryptocurrency space, and it is only a matter of time before they are developed into mature products sought after by traders and LPs.
In the coming months, many of the mentioned protocols will be launching beta versions and actual products for new trading tools. The next improvement for on-chain derivatives, including perpetual contracts and options, will be the introduction of the ability to leverage long (or short) any asset. The question of "Where can I long PEPE" will be answered by providing leveraged liquidity trading channels for mid- to long-tail assets.
AMM-driven trading products pave the way for a new trading paradigm and have the potential to enable new DeFi paradigms supported by other protocols. This includes options, perpetual contracts, volatility trading, and other leverage-based products. The improvement in trading experience will provide a more outstanding experience that can even rival existing products in the market.
