The arrival of the first wave of DeFi protocols including Aave, Compound and Yearn could not have made a stronger statement. These platforms have offered a glimpse of the future of borrowing and lending and the global credit market, currently valued in the trillions of dollars. Ease of use and the added incentives of using the protocols make it way attractive than using centralized, bureaucratic alternatives. One of the next stops for DeFi is the explosion of on-chain derivatives. Currently, there are a lot of factors that bode well for the adoption of on-chain derivatives including:
· They are trustless, censorship resistant & require no KYC.
· The success of defi protocols for lending and borrowing has boosted confidence in more complex protocols.
· Counter-party risks for trading on centralized exchanges.
· Composability of crypto leads to more innovation and value capture.
· Incentives for participation including yield farming, and earning governance tokens make it easy to attract liquidity once you build a robust platform.
· The emergence of layer 2 solutions on Ethereum, boosting speed and reducing transaction costs.
In most markets, derivatives are multiples bigger than the spot market. On 23 May 2021, the combined daily volume from spot decentralized exchanges stood at about $9 billion, a figure that is set to grow, as more people adopt crypto. And that figure is lower than the total volume transacted on centralized exchanges. In their turn, decentralized derivatives protocols are just heating up with Perpetual Protocol leading with $330m in daily volume on 23 May 2021, which is by far the highest volume on any decentralized perpetuals exchange. Spot decentralized exchanges have been around longer than their derivatives counterparts so this difference shows the room for growth for decentralized derivatives protocols.
Coin-margined & USD-margined perpetuals
Programmable money allows builders to rethink or extend what derivatives could be. Pika Protocol is an emerging project on Eth Layer 2 that is a combination of: perpetual exchange and a stablecoin. Pika Exchange is a non-linear and inverse swap exchange meaning leverage positions entered on the exchange are settled in the base currency for example, an ETHUSD contract is quoted in USD but settled in ETH. The other type of contract available on leverage exchanges is a linear contract: this is settled in the quoted currency, it’s easier to understand and behaves linearly.
From the image above, you can see the disparity between USD and coin margined perps, which is the usually the case on crypto futures exchanges. USD margined perps have lower liquidity due to lower popularity hence they throw off funding value since it is harder to keep them aligned with spot. Pika protocol uses the more popular coin margined perpetuals.
Long your longs
The value of inverse contracts get exponentially smaller and larger as the price of the underlying rises and falls respectfully unlike a linear contract which is tracked in USD. This gives traders exposure to the underlying asset, essentially ‘longing your longs’ in the event of price appreciation. If you believe in the future of cryptocurrency, you would not want to miss exposure to the underlying.
On a perpetual swap exchange, you can create a synthetic USD by combining Ether and a 1x short ETH/USD inverse perp contract. The underlying can be Ether, Bitcoin, BNB, you name it. Creating synthetic USD is one of the ways to stay neutral in a perp exchange, neither long nor short. It is this mechanism that is used to mint PIKA stablecoins. Just like that you can create tokens pegged to the value of 1 USD without having to own actual dollars. Since by going short effectively locking your capital, exchanges offer some incentives for this, for example, lending the synthetic dollars to earn interest.
According to Arthur Hayes, the CEO of Bitmex, “Why do market makers lend dollars? A market maker who goes short derivative must purchase Bitcoin as the hedge. They will purchase Bitcoin with dollars. Therefore, they must be compensated by a positive interest rate on their synthetic dollar to overcome the opportunity cost of lending dollars in other investments.”
Pika Exchange offers users more value on their capital than what they can get on centralized perp exchanges through:
-Earning funding(interest discussed above), which is coded into price.
-Utilize the NFTs of their leveraged positions within the wider crypto ecosystem(composability).
-Holders of PIKA tokens can also earn trading fees.
- Staking mechanism is expected to be further built into the system.
An additional unique feature of Pika Protocol is the use of bot-less liquidation mechanism. Currently liquidations in DeFi are triggered as cron jobs by external bots. The main undoing of this design is the speed: the risk of failing to liquidate all positions is there since you can only liquidate one trade at a time. In severe market crashes, this can eat into the DeFi protocols’ insurance funds. Pika Exchange uses a workaround that involves a hard-coded liquidation buffer value which is tracked and activated within each trade execution automatically.
All smart contracts are vulnerable to exploits, which is something most of these protocols ensure to protect against. Exploits can result from unseen vectors or from negligence therefore it is most important for users to conduct due diligence before interacting with these platforms.
Pika Protocol should be launching in a few weeks, in the meantime, you can check out their website or join their communities. For more information on Pika Protocol:
NB/This is not financial advice.