Author: GABE TRAMBLE

Translation: DeepTech TechFlow

Introduction

For some, automated market makers (AMMs) are the only place of interest in decentralized exchanges (DEX). Due to factors such as low liquidity and reliance on traditional market makers, centralized exchanges typically exclude these assets. Whether it's Uniswap, Curve, Balancer, or aggregators like MetaMask and 1inch, AMMs have facilitated trillions of dollars in value transactions since their inception 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. Unlike traditional CEX, which requires manual integration of assets, AMM can seamlessly deploy and trade any ERC-20 token as long as someone provides liquidity. This is because AMM allows anyone to deposit assets and become a market maker without needing to be an institutional entity as in traditional finance (TradFi). Market makers increase liquidity on exchanges by providing buy and sell orders to ensure that users can execute trades without other users. They make money by exploiting the price difference between buy and sell prices.

However, most spot AMMs are very basic, usually only supporting 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 transform their liquidity into other trading primitives.

In the product world, it is often said that a product needs a tenfold improvement to replace existing products and gain significant adoption. The introduction of DEXs like Uniswap has solved the liquidity problem by allowing users to create markets for any ERC-20 token at lightning speed.

DEXs like Uniswap and Curve have been battle-tested for a long time and can be used as primitives for other products.

Similar to DEX spot markets, perpetual futures (Perps) and options, among other trading products, are also fiercely competitive and still dominated by CEXs in terms of trading volume. Despite the dominance of CEXs, there are still huge growth opportunities for perpetual futures, options, and other trading products through the composability of DeFi, stacking of DeFi "building blocks," or applications that can be built on top of each other.

Most on-chain perpetual futures and derivatives have only a few assets, use oracles, and are susceptible to liquidity issues. Without sufficient liquidity, derivative exchanges cannot operate and attract more users, which is the so-called 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 a price range (Uniswap v3).

Uniswap Moments 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 value skyrocketed to tens of billions of dollars in just a few weeks. During this extremely volatile period, traders repeatedly asked, "Where can I go long on $PEPE?"

Despite the surge in popularity of PEPE, attracting tens of billions of dollars in trading volume, initially only spot markets could trade the asset. Several weeks later, some exchanges began to support perpetual futures (Perps) trading, which has remained the only source of trading, even to this day, for $PEPE on some exchanges. Even on some exchanges that support $PEPE trading, many traders believe there are issues with liquidation and settlement, which are core issues 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's issuance, similar to Uniswap.

There is a significant speculative demand for crypto assets, especially in terms of leverage. In addition to leverage, these products provide good tools for hedging LPs' positions in assets.

Perpetual Trading Products

Many on-chain perpetual contracts rely on oracles, which may be easily manipulated for long-tail assets. Oracles transform off-chain data into on-chain data that protocols can use, typically used for price feeds. Have you ever wondered why decentralized exchanges for perpetuals only support a few assets? Most on-chain Perps and options platforms offer only a few assets aimed at achieving deep liquidity and use external oracles as a pricing mechanism. Liquidation risk is also a significant issue, as managing liquidations relies on accurate oracles and ensuring that trades can be liquidated in a timely manner to meet collateral requirements. In other words, liquidations need to be seamless to ensure there is enough collateral to cover the trades. With AMM-driven trading products using concentrated liquidity AMM (CLAMM), oracle and liquidation risks are often eliminated, as liquidity is borrowed from a predefined LP range.

By adopting this approach, traders' risks are also predefined and limited within the parameters set by the exchange protocol for closing positions. Many protocols enabling AMM LPs adopt a perpetual mechanism to determine the duration of trades, where the trade duration continues as long as fees are paid to keep the position open.

AMM and LP Fees

Concentrated Liquidity Automated Market Makers (CLAMM) and Constant Function Automated Market Makers (CFAMM) constitute two-sided markets involving liquidity providers (LPs) and traders. For traders, the experience of AMM products is mostly similar. On the other hand, many exchanges strive to optimize the experience of providing liquidity, as it often leads to losses. In many cases, LPs need 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 important to note that not all LPs follow a HODL strategy. A core improvement in 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 for providing liquidity.

For some AMM-driven derivatives, such as infinite pools and Panoptic (Panoptic Option Sellers), LPs can generate fees when within the range and commission fees when outside the range. When LP tokens are outside the range, they can be used for the protocol's volatility products, whether it's leveraged trading, margin trading, or options trading.

AMM LP-Driven Trading Products—How Do They Work?

Currently, several protocols are designed to utilize CFAMM and CLAMM liquidity for trading. Some of these trading products include leverage and margin trading, options products, perpetual futures, and more. While this concept is still novel, many developers have found an opportunity to fill the liquidity and asset gap for major assets and long-tail assets in trading products. The table below shows the protocols, their liquidity AMM, and the trading products created:

Let's further explore the mechanisms and designs.

Perpetual Options Mechanism Design

Protocols like Panoptic and Smilee utilize concentrated liquidity LPs to support their trading products, specifically including perpetual options and volatility trading. Among the few protocols that utilize existing concentrated AMM liquidity, each protocol presents slightly different architectures and implementations in building trading products.

At a high level, the protocols extract concentrated liquidity from AMMs such as Uniswap v3 or their own AMM and allow traders to borrow these assets. Traders then redeem the underlying LP tokens to obtain a single asset, simulating long or short positions limited to the concentrated liquidity range. Due to the nature of concentrated liquidity positions, they always consist of 100% of one of a pair of assets (e.g., USDC/ETH) when outside the range. 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. Based on their trading strategy, they can sell the redeemed tokens to convert them into directional bets.

Example with ETH Long Position

Perpetual Options Mechanism Design

Taking perpetual options as an example, suppose a trader wants to borrow a USDC/ETH LP token, where the price of ETH is $1000. The trader wishes to go long on ETH, so they borrow the USDC/ETH LP token outside the range at a price lower than the current price, which is worth $1000 USDC. The LP token is worth $1000 USDC because the current price has moved to the right side of the range, causing the LP providing liquidity (the option seller) to hold 100% USDC. The exercise price for the option buyer can be considered as the midpoint of the LP range; in this example, we will use $900. As the trader is long, they redeem the LP token worth $1000 USDC and exchange it for 1 ETH also worth $1000 USDC. If the price of ETH rises to $1500, the option buyer can exercise the option by selling 1 ETH at $1500, as the value of ETH now exceeds the value when the option buyer purchased it, allowing them to repay the lender and gain an additional profit of $500. The option buyer only needs to repay $1000 to the LP, as this is the endpoint of the range where they provided liquidity.

The protocol typically abstracts most of the complexity. Users may need to deposit collateral to fund their positions, choose the position duration (if included), exercise price, and trading direction.

If the trade does not go as planned and the price of ETH falls to $800, exceeding the LP range in the opposite direction, the borrower will now owe 1 ETH instead of USDC. As 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 (DEXs) manage the underlying assets of protocols like Panoptic to ensure LPs are rewarded. Unlike pre-paying a premium to purchase options, Panoptic requires users to have initial collateral in their wallets to pay flow fees similar to funding rates. Collateral is required to ensure the payment of fees. The fee is based on the realized volatility and liquidity utilization in the underlying Uniswap pool to determine how much the option buyer should pay the seller (LP). When traders stop paying funding fees or the funding fee exceeds their collateral, their positions will be liquidated.

In both examples, the option seller continues to receive flow fees to maintain their position. This is a general overview related to Panoptic, as each protocol has different approaches to managing liquidity, providing leverage, calculating collateral, premiums, and funding fees.

From a bird's-eye view, the trading is two-sided, where LPs deposit their LP tokens into the protocol and receive volatility fees, and traders can open positions. LPs are incentivized to provide liquidity as they can earn rewards beyond other means. A core issue for LPs in AMMs is that their fees may not be sufficient to offset the risk. Finally, profitable traders can exercise their profitable positions or continue to pay funding rates to the LP to keep the trade open.

Perpetual Futures Mechanism Design

For platforms like Limitless or InfinityPools, the mechanism is similar to perpetual options. However, users can deposit collateral, which will be combined with the borrowed LP. The required collateral and leverage are determined based on the distance from the spot price. Similar to 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 mechanism design is very similar to the previous example, with the main difference being the collateral deposited by the user to cover the maximum loss when the trade moves in the opposite direction. Both Limitless and InfinityPools claim to offer hundreds to thousands of times leverage, depending on the distance between the range and the current price. If a trader incurs a loss in the trade, the protocol will close their position and pay the collateral to the LP to ensure the LP's position as a perpetual futures seller is intact.

Market Opportunities—Cryptocurrency Derivatives Trading

Traditional Financial Market Size

According to data from Sifma Asset Management, the US stock market dominates globally, accounting for over 42.5% of the global stock market value 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 $10 quadrillion, although some believe this valuation may be overstated, according to Investopedia. The upper limit of this astronomical figure includes 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, the scale of derivative trading is much larger than spot trading. The same is true for the cryptocurrency market, with most of the trading volume occurring on centralized exchanges (CEXs).

Bitmex is another centralized exchange that launched their perpetual (Perp) trading tool 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 tool in the cryptocurrency market, this product has expanded from centralized exchanges to various decentralized versions: DYDX, GMX, Synthetix, and others. Perpetual protocols facilitate transactions worth hundreds of millions of dollars every day and are the primary derivative trading products in today's cryptocurrency market, as they offer high leverage. This is a significant shift from traditional finance, where options dominate the derivatives market.

Cryptocurrency Spot Trading vs. Perpetual Futures

In the first quarter of 2023, cryptocurrency derivatives accounted for 74.8% of the total trading volume of $2.95 trillion in the cryptocurrency market. The market share of spot trading on centralized cryptocurrency exchanges (CEX) and decentralized exchanges (DEX) was 22.8% and 2.4%, respectively. It is worth noting that centralized cryptocurrency derivative exchanges such as Binance, Upbit, and OKX lead the market. According to the 2023 cryptocurrency derivatives report by Coingecko, although derivative trading volume increased by 34.1% year-on-year, the growth rates of 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, and Smilee are driving industry development by offering high leverage without the need for oracles, clearing, and even in some cases, providing high leverage. With the support of concentrated liquidity, AMM LP trading products eliminate some prominent weaknesses, such as managing oracles and clearing.

Risks

While these products may be exciting, risks still exist. The most significant is smart contract risk. Since all AMM-LP trading products control LP tokens or require deposits, there is a potential smart contract risk if there are vulnerabilities or errors.

Credit Liquidity Risk

Additionally, there are some issues with the economic design mechanism. The Gammaswap team investigated the feasibility of developing on Uniswap v3 and CLAMMs, as they believe there is "credit liquidity risk." This risk involves liquidity providers (LPs) being unable to pay long positions or vice versa, typically due to liquidation issues caused by excessive leverage. Due to concentrated liquidity, automatic market makers (AMMs) like Uniswap have low liquidity areas or "ticks," and price movements outside the range may lead to excessive slippage, even for stable trading pairs. Gammaswap chose to build on the constant function model, believing it is a more robust liquidity primitive.

In Uniswap v3, there may not be enough liquidity to meet the LP's returns. Unlike traditional finance, where the Federal Reserve can inject liquidity, there are no similar entities in the DeFi space. Additionally, there are no oracles traditionally used for clearing, adding complexity to this issue.

Panoptic addresses credit liquidity risk by requiring pool creators to deposit a small amount of both tokens across the entire range, and Panoptic traders cannot remove these deposits. The initial deposits ensure there is a certain level of 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, and traders can open positions with a simple click of a button. In contrast, options and potential perpetual options introduce additional complexity, such as Greek letters, exercise prices, and other traditional option knowledge, which may hinder user adoption. This is especially likely among retail investors, who are often the earliest adopters of new trading tools. Additionally, introducing volatility trading also adds complexity to the user experience. As the cryptocurrency space has already faced challenges with user adoption, some complex but powerful products may struggle to gain widespread acceptance due to their financial complexity.

Conclusion

Perpetual futures and options have found a 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.

Over the next few months, many of the mentioned protocols will launch beta versions and actual products of new trading tools. The next improvement in on-chain derivatives, including perpetual contracts and options, will be the ability to go long (or short) any asset with leverage. The question "Where can I go long on PEPE" will be answered by providing leveraged liquidity trading channels for mid-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 enhancement of the trading experience will provide a superior experience and may even rival existing products in the market.

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