On chain derivatives

The traditional finance derivatives market

Derivatives in the TradFi world are one of the most significant financial instruments valued by the gross market value of all contracts to be approximately $12 trillion. These contracts include various underlying assets from commodities, equities, and forex. Derivatives allow you to take a leveraged position, hedging your spot position and the ability to trade any asset without the hassle of holding it. A bank in the US can go long/short on a European country’s credit market by buying its derivatives and not getting into the regulation of the underlying asset.

Crypto derivatives market on CEXs

With everyone trying to get into cryptocurrencies and blockchain technologies, these centralized exchanges come under severe scrutiny and regulatory risk. As we just saw with FTX collapsing, we will continue to see many more centralized entities within crypto collapse.

Most of these entities often bypass regulatory issues by positioning themselves off-shore offices but still exposing traders’ assets to growing amounts. The crypto industry peaked in valuation in November with a $3 trillion dollar market cap, with Bitcoin being about 1.25 trillion of the total market cap. The Bitcoin derivatives market also hit an all time high of about 30 billion in open interest in November; right now, there is only about 10 billion in open interest on Bitcoin. The crypto derivatives market is currently dominated by CEXs like Binance, Okex, and Kraken, with Binance accounting for over 50% of the total flow. This market used to be fueled by the price action , volatility of crypto assets, ease to use leverage and most importantly, the familiarity of order book exchanges by market-makers that provide deep liquidity. Right now, the orderbook is a ghost town, and crypto is turned into a higher beta S&P 500.

When FTX was still around, it generated $85 million in revenue in 2020, only to destroy its previous revenue in 2021, making over $400 million in revenue. During many of these crashes, with Bitcoin and Ethereum falling over 10% on the day, many of these CEXs crashed, shut down, or had their algorithms shut off or even, in some cases, liquidated accounts by mistake.

Traders and users have often questioned CEX’s and their liquidation processes, leading to questions about whether we incorrectly liquidated. Another alleged accusation of all these CEXs offering perps was that they would have desks trading against their users. We just saw our confirmed case with Alameda and FTX trading against their customers.

Why we need on-chain derivatives

There are two significant benefits to on-chain instruments-

Transparency

Non-custodial

2022 saw the rise of DEXs, which propelled the whole DeFi ecosystem for the entire world to notice. On-chain derivative products like Lyra, Synthetix, Dydx, Perpetual Protocol, and GMX cumulatively made more than $480 million in revenue over the last year. With a massive increase in the past month due to FTX collapsing. Compared to Binance Exchange which will have about $20 Billion in revenue in 2021. It proves that these decentralized applications are still in their infancy and have yet to capture a considerable market share.

Transparency

When trading on chain, everything is transparent. There are many Open and free-to-use platforms like Dune Analytics that give anybody the possibility to take a look at data. These useful tools enable anyone to shine a light onto different aspects of DEXs, even allowing you to write your own queries to obtain the information you need.

Non-custodial

I think we all have heard the quote ‘not your keys, not your coins’. This is often a great piece of advice to crypto users and traders, but when trading on CEXs this gets thrown out the window. When you deposit funds to a CEXs, you lose control of your assets because you don't have control of the private key, as we saw with FTX. Blockchain and crypto started in 2008 after the financial crisis because its entire purpose was to prevent the next crisis because users were not aware of what was happening. Only DEXes embody the true spirit of crypto which is decentralized in nature.

On-chain Derivatives — Current Issues

While decentralized derivative platforms and blockchain as a whole are in their infancy, there are still some problems that need to be addressed.

High L1 gas fees and poor infrastructure

When trading derivatives, more times than not, the users decide to involve leverage. Traders want to place orders quickly and need a solution to solve this. The only solution currently is an Ethereum layer two solution, a low-gas solution. But even a layer two doesn't work well when overloaded with transactions. In addition to gas fees, the UX infrastructure, like wallets and RPCs, is far from reliable.

Impermanent loss

We constantly hear users saying yes; I'm Market making in a liquidity pool. I believe that isn't market-making. Market making is the concept of providing liquidity through limit orders. Most market makers have stayed away from automated market makers because of Impermanent loss, where most, if not all, these on-chain derivatives are built.

Capital inefficiency

Most DeFi protocols are capital inefficient and designed around over-collateralization, meaning someone supplies capital to trade and can only mint a fractional of what was deposited. Since the beauty of DeFi and blockchains lie in open-source most of these problems are being solved separately. Plugging them in via the composability of blockchains, the future of on-chain derivatives looks brighter than ever.

Conclusion

There has been tremendous growth in the decentralized derivatives market over the last 12 months, and I expect this to grow even more in the coming 24 months. The infrastructure is being put in place that will support the next wave of innovative decentralized platforms. The decentralized derivatives market might be the next big market for crypto, as we saw the growth of UNiswap and Sushiswap in the past cycle. The next 10x is in the decentralized derivatives market.