The Problem and the Solution –
It is kind of crazy to think how far we have come as an industry. Real-world adoption was once the biggest meme on CT and now, as if it popped up out of nowhere, it is part of our everyday lives.
SHIB is on the news, stablecoins are discussed in congress and my native land thinks it’s a good idea to create a CBDC called BRitcoin, apologies in advance for that one…
With that, the on-chain world is becoming more and more active and we as an industry are all the better for it. I, for one, have certainly seen a huge spike in interest from newcomers to this space looking to take their first steps into the realm of DeFi.
Whether it be for DEX trading, minting NFTs, staking or yield farming, every single metric is booming. But, we still have a long, long way to go until this becomes the preferred choice and more importantly the norm.
If you have a look at CEX trading volumes from the top exchanges around the world today alone there was $197bn in trading volume from spot and leverage traders.
It is important to note that FTX released this report highlighting that they found that around 17% of this trading volume is fake… all the more need for on-chain transparency.
Then when we look at daily trading volume on-chain… for spot markets, we are looking at around $8bn, according to CoinGecko. So, we have a lot of room to grow here and an awful lot of potential for decentralised exchanges if this trend continues (which it will).
This is backed up by monthly data that is seeing us moving in the right direction to increasingly positive on-chain DEX trading volumes.
Data from Dune Analytics – DEX metrics.
And when we throw it all together with this excellent metric from The Block, we see an increasingly positive trend for DEX vs CEX trading.
This is probably for a number of reasons. Increasing regulatory scrutiny surrounding derivatives trading in the US, China’s recent outright ban, increasing awareness of DeFi and overall, users becoming more and more comfortable with the on-chain process.
No matter the reason, the future seems extremely positive for all those who are building decentralised exchanges and all those investors who are holding the project’s native tokens.
Given that futures trading accounts for around ⅔ of Binance volume whilst making up around ¾ of FTX’s, it isn’t out of the question to say that there is an appetite for leverage in crypto. Even when taking into account leverage will boost the volume profile of these figures, there is still a highly significant amount of activity per day for this product.
A brief overview for the uninitiated (If you have an understanding of perps then you can skip this section) –
So, the predominant futures product in crypto is a perpetual futures contract. These were actually spawned from within the crypto industry by BitMEX around 5 years ago and are still technically crypto-native. Cool, ey?
They are an innovation based on a traditional futures contract that allows people to speculate on the price of an asset. People can go long (bullish) or go short (bearish) all the while never actually holding the underlying asset. The perp is synthetically derived from the underlying asset, hence the derivatives market…
BitMEX saw that there was a disconnect with the way a traditional market futures product was shoehorned into a 24/7 crypto market, mainly due to regular futures having a set expiry date etc.
“In a market that never stops, why should a crypto futures product need to expire?”… – BitMEX anniversary blog post.
So this meant that a perp would in effect never have to be closed. The position could be kept open for as long as the trader desired.
This threw a small spanner into the works with the price of the derivative (BTC-PERP, ETH-PERP etc.) often drifting from the spot price of the asset. So, to counteract this, a funding rate was set.
All this means is that if the perpetual futures contract price of the asset was greater than that of the spot price of the underlying asset, then those that were long and adding to this divergence would have to pay those who were short a small premium for doing so.
The same is true for the opposite situation. If the price of the futures contract was lower than the spot price of the asset (indicating the leverage traders are bearish) then those that were short would have to pay those that were long a small premium.
FTX for example have funding payments on the hour and a lot of speculators like to use this metric as an indicator for broader market sentiment.
The funding you would pay is based on the difference between the futures price and the spot price and also your position size. So, as you can imagine this incentivises arbitrageurs to take large positions on the other side of the trade when funding is high so they can scoop up some of that funding available. This inevitably brings the divergence between futures price and spot price back to neutral, smart eyy?
How a Trade Would Work –
ETH is currently trading at $4000. Bob thinks that ETH is going to be $5000 soon enough, but he doesn’t know when… Bob wants to take that trade and has 1000 USDC that he is willing to put down to test his thesis.
Bob is also super confident in this trade so he decides to lever up and use 10x leverage. Now Bob is entering a position with a notional value of 10,000 USDC (minus fees etc.).
Bob is immediately correct and the price moves up 10% to $4400.
Due to Bob’s notional position size of 10,000 USDC, he is currently in profit, 1,000 USDC or 100% from his initial 1000 USDC he placed on the trade.
The same is true in the opposite direction… in the most basic of examples (we will get to the technicals later), if the price of ETH was to drop to $3600, a -10% move from his entry, then the 1000 USDC he put down as collateral is liquidated.
All make sense? I will go into maintenance margin a little more in the Market Taker’s article, so the numbers aren’t exactly 100% correct for now, but it is just an example for newcomers….
So, there are obvious benefits to leverage when you are correct and obvious risks when you are wrong.
For me, leverage is not a tool to be used to increase your position size but rather to limit the amount you need to put down on a trade. This is where I believe a lot of people go wrong in crypto. It isn’t the product itself that is an issue, it is how people think it should be used.
Right, so now I have bored you to death with things you already know, let’s take a look at one project that ties this all together; Perpetual Protocol and its game-changing V2 update, Curie.
Perpetual Protocol v2, “Curie” –
Perpetual Protocol (Perp) is a decentralised exchange that is dedicated to leverage trading via perpetual futures contracts. The protocol went live in December 2020 on Ethereum mainnet after around 2 years of building and a name change from “Strike”… much better name IMO.
Since then v1 has existed on Ethereum and also on xDAI in a bid to reduce fees for traders. The protocol is set to release its V2 “Curie” update which will be available on Arbitrum. Perp v2 testnet is available now with 10,000 paper-USDC for users to try out. Trust me, it is excellent.
I don’t know about you but I like to follow what the big dogs are interested in and Perp has one of the strongest teams of strategic investors I have seen across any project.
So after a successful launch and over $31bn in trading volume later, the team have decided to make the trading experience even better for its users with the rollout of v2 on Arbitrum.
V2 on the surface is going to make the user experience infinitely more exciting due to reduced latency, cheaper fees and much better slippage by operating on UniSwaps concentrated liquidity v3 pools.
But under the hood, there are some key changes to how the protocol works too… So let’s take a look at those.
Arbitrum – Well, everyone knows how this is going to go. The trading UX is going to be extremely efficient, mimicking the off-chain experience with drastically lower fees. I expect the protocol’s deployment on the favoured layer 2 to draw in a ridiculous amount of volume. More on why this is great news for PERP holders later…
Concentrated Liquidity – Perpetual Protocol uses what is known as a virtual automated market maker (vAMM). The protocol would use the traditional x*y=k model of an AMM to determine the price of the futures price of an asset.
How the vAMM works –
You want to open a 2x ETH long position. So you take your 100 USDC as collateral and deposit it into what is known as the Clearing House.
From there you direct the Clearing House that you would like to open a 2x ETH long. So as we have opened a position of the notional size of 200 USDC (2 x 100 USDC), the curve then takes this rebalance between “x” and “y” into account and gives you an initial entry price.
It is important to note that in V1 there aren’t actually any liquidity pools at play here and the price curve is virtual, based on the number of longs and shorts open for that particular trading pair.
Once a position is closed the balance is settled in USDC.
So in short… USDC in, as collateral and hopefully more USDC out as collateral + profit. No actual tokens are traded as the x * y = k curve is used to determine the price of the derivative being traded.
So that is how V1 operates on Ethereum layer 1 and xDAI. With the new V2 implementations of UniSwap v3, it is slightly different.
One of the main drawbacks of the price curve on UniSwap v2 and basically any other AMM on the market is that those who supply liquidity effectively supply their assets across the full range of the curve, resulting in high slippage for traders.
This isn’t great as those who are trading large balances are not going to want to take the hit on additional slippage if they don’t need to and hence will hold back on using an exchange.
UniSwap V3 pools allow users to supply their assets at a concentrated range along the price curve. This increases capital efficiency for the LPs whilst also increasing the trading experience through reduced slippage.
So, how does this affect Curie and Perp V2?
Well, some of the main key differences with Perp V2 are that there will actually be UniSwap v3 liquidity pools. These will be comprised of vTokens (vETH vUSDC vBTC etc.).
Those who wish to become a market maker for these can deposit USDC into the Clearing House and then mint their desired ratio of vTokens.
For example… I want to be a market maker for the ETH-USDC pair on Curie… I can then deposit USDC into the Clearing House and tell the contract how much of each vETH and vUSDC I want.
Following that, I would take these tokens and supply them as liquidity to the UniSwap vETH-vUSDC pool on Perpetual Protocol. (I will go through how to do this in detail in the Market Makers article, coming soon).
I can select the area on the curve I wish to supply these assets, which if optimised correctly will generate handsome trading fee rewards. From launch, it is suggested in the docs that a 0.1% trading fee will apply with 0.09% of this going to makers.
The really mind-blowing thing is that the Clearing House in V2 will actually allow users to leverage their LPs. You can effectively deposit 100 USDC and mint up to 10x this in your desired vTokens… We really are venturing into the realms of DeFi 2.0 here and I am all for it.
Listening to this interview recently with Dani from Popsicle Finance I think that there is going to be an extremely cool opportunity for market makers of Perp V2.
Perpetual Protocol V2 – A Guide for Market Makers, Coming Soon…
So, now that we have vTokens, LPs and deployment on Arbitrum, the protocol will trade as efficiently as physically possible.
Just to clear something up to prevent any confusion… for those wishing to trade on V2, you will do this through the Perpetual Protocol DApp. This is the UI for the whole leverage trading experience and only uses the Uni v3 pools on the back end to facilitate trading.
I will also go through a full tutorial of how to use Perpetual Protocol which should be with you early next week.
Cross-Margin Mode and Multi-Asset Collateral.
If you have ever used FTX perps then V2 will offer a similar trading experience to that. FTX is the CEX of choice for the vast majority of people I know from within the industry. The whole “Built by traders, for traders” is their philosophy, so taking this on-chain is going to be really cool to see.
On top of that USDC won’t be the only collateral that can be used going forward. If a user wants to put down ETH as collateral to open a BTC long/short then they will be able to!
Permissionless Markets –This is one of the most exciting additions for me personally. We all know how fast narratives are born in this space. One minute it is the Metaverse, the next it is DeFi and then sometimes meme tokens begin to shine.
With permissionless markets on V2, users will be able to trade, on-chain, with leverage on a whole host of tokens and emerging projects that users wouldn’t necessarily even have access to on a traditional CEX.
This is great for users who wish to stay on-chain and is an excellent use case for the protocol.
Using SHIB as an example from last week, it hit nearly $40bn in volume in one day. Now, think what you like but if you are a trader, you want volatility, if you are a protocol you also want volatility and if you are a PERP holder… well, more on that below.
The PERP Token –
The PERP token doubles up as a utility and governance token. There is a hard cap of 150,000,000 PERP with around 55,700,000 currently in circulation. Of the 55m PERP in circulation, there are around 28m staked, at the time of writing.
Users can stake their PERP to earn staking rewards and trading fee rewards. Currently, you are looking at around 27.7% APR. Now, this is for V1 staking and there are expected changes to happen for V2 stakers.
This is how V2 staking is expected to play out…
There are still some internal discussions as to how this trading fee is correctly distributed. From the recent AMA regarding V2 the question was asked:
Q: Will trading fees still be 10 basis points and how will it be split between stakers and makers?
A: The split is still yet to be decided. To be completely honest, because we’re not entirely sure how the protocol will behave. Just to give a little bit of context, the reason why we’re unsure yet is we have to be quite delicate in how we figure out how to do this. So if we take two extremes, let’s say if we take the extreme and we give everything to stakers, then there is no liquidity providers that actually want to provide liquidity.
Conversely, if we give all of the incentives to the liquidity providers then there are no stakers. So there’s no point in staking and no one will kind of want to be the backstop.
We basically just have to find the sweet spot between the two and especially because as a staker, your risk has actually decreased quite a lot from v2 versus v1 because the insurance fund open interest skew problem is now solved as well. So we don’t have an answer yet but we’re going to monitor and hopefully, with the help of the community we can figure out the best balance.
It makes sense for me personally, this split is going to have to be decided on by the community once they have seen how the protocol acts, hence the governance aspect of the token. There needs to be an optimal incentive for PERP holders to stake, whilst also creating an incentive for market makers.
But, when this is ironed out and decided upon PERP holders will certainly have a lot to look forward to with this feedback loop.
I can almost definitely say that launching on Arbitrum is going to be incredible for volume on V2. The more volume, the more trading fees, the more rewards for makers and PERP holders.
It is difficult to say how high these rewards will be due to the undecided trading fee split, but if we take a look at some projected numbers and hypothetical situations we can make some assumptions…
Comparisons to Other DEX’s and Competitors –
Before their deployment on layer 2, dYdX was drawing around ¼ the volume of Perpetual Protocol. This was mainly due to the larger selection of tokens available on Perp, the much more favourable funding rate and also reduced trading fees for market takers.
At its height, Perpetual Protocol hit around $581m in 24 hours of trading, on Ethereum mainnet, which would have generated around $581,000 in trading fees, in one day… That is kind of ridiculous. In a good way…
Since their deployment on layer 2 dYdX has achieved steady volumes of up to $2bn a day.
So what are the chances of Perpetual Protocol taking the majority market share from dYdX?
Well, for one, I think this will only increase the total market and hence increase the total on-chain perps volume. If Perpetual Protocol can deliver the same attractive user experience that solidified them as the layer 1 DEX of choice for leverage traders, then they will certainly be on to a winner.
Even taking a modest 50% of dYdX’s volume would land them at an average daily volume of around $1bn which is 2x higher than their ATH volume on layer 1… bullish.
There are reasons they could surpass dYdX too, UX aside, the main one being Arbitrum. dYdX runs on StarkWare, a zk-scaling solution with a total of $1bn TVL, which kinda matches up well with DeFi Llama’s recorded TVL for dYdX of well… $1bn…
Arbitrum however is steadily increasing towards the $3bn mark without Perpetual Protocol going live yet. I dare say we may see a huge spike in TVL once Perpetual Protocol V2 goes on mainnet… The ease, accessibility and familiarity of Arbitrum will also lend itself well to adoption in my opinion.
To work out a fair value for PERP and what the protocol rewards would look like for stakers, I plugged some numbers into THIS SHEET which I made (apologies for my terrible Google sheets skills, but it does the trick).
So based on the first table of average daily volumes of $1bn, this at 0.1% results in $1m a day in market takers fees (makers fees aren’t taken into consideration here…). So, annually, a $365m dollar revenue-generating protocol of which there will be an undecided amount given to stakers.
Even if this is 10% (of the 0.1% trading fee), this would yield roughly $700,000 a week in staking rewards… Which is incredibly impressive. Using the 1,700 current sPERP holders as a ballpark figure generates an average of $411 of yield per week based on the average sPERP holding.
What is important to note is that if the volume is higher and the trading fee split is also higher then naturally the staking rewards from transaction fees will also be much higher.
Take all of this with a pinch of salt as the fee distribution has yet to be decided but this is potentially what PERP stakers could be looking at.
What is undeniable though is the protocol revenue based upon these numbers. Hitting anywhere close to the $365m revenue over the next year would sit them in the top 5 projects according to Token Terminal. Even at 1/10th of these numbers generating $36.5m a year in revenue would sit the protocol in the top 11 somewhere in between 1Inch and Compound.
To reach $36.5m in revenue a year the protocol would need to hit an average of $100m a day in volume which given that Perp is achieving these numbers on Ethereum Mainnet, I think this would be an extremely low estimate.
As always, take what I say lightly as I am an idiot, but you have to admit, the numbers do add up.
Testnet Responses –
This past week has seen the Perpetual Protocol V2 testnet rolled out which I tried and enjoyed very much (hence why I have taken so long to write this article ffs…). Over $470m was traded over the course of the 7 days, with the majority coming in on the last day.
Bullish stats that came out of the test week –
Based on liquidity and trading fees makers would roughly receive 119% APR!
For each dollar, there was roughly $23 in trading volume and effectively $0.023 in transaction fees.
900% less slippage… this is a big one thanks to UniSwap v3 pools.
4,600% cheaper than Ethereum mainnet
Concluding Remarks –
All in all, I believe it is a very very good time to be a DEX and/or a token holder of such projects. With the obvious trend indicating that users are increasingly coming on-chain to trade, the adoption of spot and leverage trading will almost certainly increase by orders of magnitude.
We often forget how early this space still is as it consumes a lot of our lives 24/7. Taking the blinkers off for a second, the daily crypto trading volume is infinitely smaller than traditional markets and DeFi/ on-chain trading is a drop in the ocean in comparison.
That allows excellent products such as Perpetual Protocol to capture the enormous upside through adoption and increasing awareness of crypto and such derivative products. I expect on-chain leverage trading to grow now that we have a viable trading environment with layer 2s such as Arbitrum and I also expect users to not necessarily have to go back to CEX trading if they don’t want to.
Increasingly invasive regulatory scrutiny is certainly pushing DeFi in the right direction, but not because people are looking to evade the law (I mean, some certainly are) but rather it is the natural progression for a decentralised world. Permissionless trading environments where anyone can trade freely and as openly as they like, with or without leverage.
Perpetual Protocol has been riding the wave for on-chain leverage trading with great success and now with V2, they are going to seriously come into their own. I expect the protocol to explode. It is a pretty simple business model in all honesty. Build a great product, charge a small trading fee and generate revenue and profit in doing so. Simple, effective and the addressable market hasn’t even begun to wake up yet.
I do see a world where ALL trading is done on-chain, although we may be a while away just yet. I expect this in the next 10 years or so and those that are positioned to benefit from the run-up to it are going to do extremely well in my opinion.
Don’t just take my word for it, go try out the V2 test-net, it is still available with 10,000 USDC in paper cash. Go try it for yourself and see how brilliant the product actually is.
I will be following this article up with a tutorial guide and also guides for Market Makers and Market Takers, so stay tuned!
If you like this kind of content and would like to have a chat about me writing something similar on a project you like or are a part of just give me a DM on Twitter or hit me up @blocmates on Telegram.
Also if you do want to start using Perpetual Protocol and also want to support us here at blocmates, you can simply click the image below to “sign up” with our referral link, thank you if you decide to do this!