Perp DEX 101

Decentralized perpetual futures exchanges, aka perp DEXs, represents asset markets that evolved solely within the blockchain financial ecosystem and is not found in traditional finance.

Understanding Decentralized Perpetual Futures

In the past, when predicting food production was uncertain, the practice of "Forward Contracts" emerged as a way for producers and consumers to fix future transaction prices and eliminate mutual uncertainty. Over time, advancements in trading methods were made to reduce inherent risks in transactions.

While forward contracts addressed uncertainties, they still left room for counterparty risks, where the other party might fail to fulfill the contract. To tackle this issue, "Futures Contracts" were introduced, enabling buyers and sellers to enter into contracts without counterparty risks under the management of a trusted intermediary.

In the cryptocurrency market, futures contracts had a fixed expiration date and required regular settlements and potential rollovers if parties wanted to maintain the contract without physical exchange at maturity. To eliminate this inefficiency, BitMex, a cryptocurrency intermediary, pioneered the perpetual futures contract in 2016, which allowed continuous contract maintenance without the need for rollovers.

With the evolution from traditional forward contracts to modern perpetual futures contracts, several problems were addressed, including the elimination of uncertainty, counterparty risk, and rollover inefficiencies. By harnessing blockchain technology and smart contracts, decentralized perpetual futures contracts can further solve additional issues like intermediary risks, intermediary costs, and offering services to the unbanked population.

The utilization of blockchain and smart contracts in decentralized perpetual futures contracts creates a trading environment that reduces inefficiencies and risks. Platforms providing this infrastructure are referred to as decentralized perpetual futures exchanges.

Current State of Decentralized Perpetual Futures Exchanges

Cryptocurreny decentralized exchanges’ spot market trading volume compared with centralized exchanges, Source: The Block

Cryptocurreny decentralized exchanges’ futures market trading volume compared with centralized exchanges, Source: The Block

The cryptocurrency market has seen futures trading volumes surpass spot market volumes, with futures often leading spot prices. However, decentralized exchanges (DEX) have shown a lower market share in futures trading, recording a maximum of 2% and currently hovering around 1.25%.

DEXs operating on the blockchain struggle to match the transaction processing speed of centralized exchanges (CEX) that use centralized servers. Therefore, focusing solely on speed will not help DEXs gain a competitive edge against CEXs. To increase market share, DEXs should emphasize composability, where various projects leverage each other's features to create diverse use cases, and the ability to grant platform ownership to users, in addition to transparency.

In conclusion, decentralized perpetual futures exchanges have the potential to revolutionize the financial ecosystem by addressing inefficiencies and risks associated with traditional trading methods. As the market evolves, DEXs must leverage their unique characteristics, such as composability and user ownership, to compete effectively against centralized exchanges.

Classification of Decentralized Perpetual Futures Exchanges

AMM Model

Virtual AMM Initial Model of Perpetual Protocol V1, Source: Perpetual Protocol Blog

The AMM (Automated Market Maker) model is a price discovery mechanism that has evolved uniquely within the cryptocurrency market. It operates on the principle of x * y = k, which automatically determines asset prices. This model was initially used by Uniswap, the most prominent decentralized finance (DeFi) protocol, to bootstrap new trading assets.

However, in decentralized perpetual futures exchanges, the AMM is different from Uniswap's spot AMM. As perpetual contracts, these exchanges do not involve actual spot exchanges but are based on the assumption that trading on the AMM occurs with the nominal amount. This is known as the Virtual AMM.

Notable examples of AMM-based decentralized perpetual futures exchanges include Perpetual Protocol, Drift Protocol, and SynFutures.

Oracle Model

Chainlink $ETH Data Feed, Source: Chainlink Website

The Oracle model provides trading services based on price data from leading asset prices with high trading volumes, rather than having the exchange itself determine the prices using AMM. This eliminates the need for costs to narrow the gap between DEX prices and market prices.

However, since the Oracle relies on external price data, there is a risk of Oracle hacking, and it may not be easy to onboard low-liquidity assets. Furthermore, DEXs relying on a specific Oracle’s data cannot theoretically become a market leader in price discovery.

A notable decentralized perpetual futures exchange using the Oracle model is GMX on the Arbitrum network. GMX is known for providing price-taker-friendly zero slippage and adequate rewards to price-makers, creating incentives for both sides of the market participants and demonstrating organic growth. Additionally, it was reported in April that GMX would utilize a new version of Chainlink, a well-known Oracle protocol, for price feeds.

Orderbook Model

dYdX's $ETH orderbook, Source: dYdX

The orderbook model is the most familiar model to traditional capital market participants. Consequently, it has maintained the highest market share in decentralized perpetual futures exchange markets for an extended period. It offers a structure where professional market makers can make price quotes at their desired prices, allowing them to generate additional income through specialized market making, leading to abundant liquidity.

However, due to the block-by-block settlement nature of blockchain, there is no fully transparent "decentralization" that can support the orderbook model. As a result, the orderbook itself is supported off-chain, and only the execution and settlement of trades are recorded on the on-chain blocks.

Notable decentralized perpetual futures exchanges using the orderbook model include dYdX and Injective. Additionally, Alex orderbook and Clover, which have launched testnets, are also in existence.

Conclusion

Each model, AMM, oracle, and orderbook, has its advantages, limitations, and roadmaps to address challenges. It is currently unknown which model or protocol will emerge as the winner in the competition of decentralized perpetual futures exchanges. There is also a possibility that the entire market of decentralized futures exchanges may not succeed. Nevertheless, observing the development of the nascent derivative DEX industry itself holds significance, and it is crucial to pay attention to new protocols that may provide ideas to resolve market inefficiencies in the future.

References

• Earl Cho, Perpetual DEX Part 1: The Significance of Decentralized Perpetual Futures Contracts, 2022
• GMX, Gmx v2: new low-latency chainlink feeds, 2023

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DeSpread, founded in 2019, is a consulting firm specializing in Web3 & blockchain. Consisting of practice leaders with many years of practical know-hows in all fields of Defi, NFT, Metaverse & Gaming, Network Validation and Web3. DeSpread provides solutions and go-to-market strategies to grow the protocol by actively participating in the ecosystem.  

Writer1: Declan Kim, Research Analyst at DeSpread
Writer2: Earl Cho, Senior Consultant at DeSpread

#Perpetual #Dex #Orderbook #Oracle #DeSpread