Introduction

While still relatively nascent, Derivative DEXs make up less than 5% of Centralized Exchange (CEX) volumes. The growing appetite for decentralized trading and options has given rise to more derivative-focused DEXs, with the likes of dYdX, SNX, GMX and more being major players in the space.

This report shares a comprehensive derivative landscape resource compiled by 0xperp (Appendix A), along with a non-exhaustive list of interesting projects in the space introduced to the alpha community over Q3 2022, including Synthetix, Kujira, dYdX and Opyn, and an upcoming AMA with Primitive in Q4 2022.

For those with no financial understanding, it is recommended to check out the Derivative Options Introductory Guide first.

Overview of the Derivative Landscape

Derivative Landscape in Defi Table

The derivative landscape is substantial, and the above Derivative Landscape in DeFi table has been compiled using resources in Appendix A by 0xperp. Appendix A covers most derivative protocols and use cases in DeFi including options, perpetual swaps, interest rate swaps, volatility, structured products, NFT options and fractionalization, staking derivatives and others.

In the summer of 2022, a leading narrative of earning “real yields” has driven attention to protocols whose revenues are derived from “real users” and not inflationary emissions. Derivative DEXes are a category of protocols where this is visibly achieved. The general market conditions have also shifted attention to derivatives for more sophisticated trading strategies to generate alpha returns in a bear market cycle. Such strategies include going delta-neutral, using options and structured derivatives, trading with power perpetuals and so on.

Building on recent innovations, users are seeing an increasing number of innovative concepts and features. This includes protocols like Rage Trade, that is built atop Uni V3 and LayerZero for cross-chain data sharing, Primitive, that proposes a novel approach to an Oracle-less AMM that opens up a range of new possibilities for trading long-tail assets, and many others (Appendix A).

Rapid innovation in the space has resulted in DEXes building out their platforms across different technology stacks, with hopes of building out a better product for its users. For instance, in the space of Central Limit Order Book (CLOB) Derivative DEXes, projects are being built on different L1s. For example, dYdX & Kujira have made the decision to build their own app-chain on Cosmos, Mango markets & Drift Protocol on top of Solana, and GMX on top of Arbitrum.

Alpha Q3 Derivative Protocols AMA Round Up

Over the course of Q3 2022, the team has introduced a non-exhaustive list of derivative projects to follow. The table below provides an overview of the design approach behind these protocols along with recent developments, as well as potential strategies or ways to participate. The projects are elaborated further in the subsequent sections below.

Alpha Q3 Derivative Protocols: Overview & Comparison

Fees make up the core revenue for DEX and it is a good proxy for user activity and success of the protocol. Below’s table makes a relative comparison of the protocols’ valuations and their differences vs a CEX. Price-to-fees ratio compares the FDV of the protocol against the fees collected. A higher ratio indicates a higher premium paid and higher growth assumptions.

_*Fees taken from token terminal that relies on protocol APIs **estimated via regression of 24hr volume (99.1K) with 0.08% and 0.15% maker and taker fees only_

While each DEX has different designs that are elaborated in the later sections, there are a few key differences between CEX and DEX in general, namely: Decentralization, Asset Custody, Regulations, Impermanent losses, Liquidity Depth, and Accessibility.

Decentralization: CEX are operated by centralized entities while DEX are typically operated by users and LP providers. Asset Custody: The CEX entity holds custody and controls access to all assets while DEX users typically have full control and ownership over their assets. Regulation: CEX are highly regulated while DEX lacks the KYC and AML standards imposed on CEX. Liquidity Depth: CEX typically has a strong base of institutional market makers and established user base that helps to provide deeper liquidity. DEX on the other hand, depending on its design, can face a lack of liquidity due to competition from CEX and other DEX. Accessibility: CEX may not always be available to everyone while DEX typically remains open and accessible to all users. Design: CEX typically uses a central limit order book system, while DEX designs can vary greatly. There're many competing designs in the space including order books and AMMs. AMM designs range from constant product, constant mean, minimized arbitraged model, concentrated liquidity (v3), virtual AMMs models and with more innovation upcoming e.g. RMMs. Each design is subject to tradeoffs and risks.

Synthetix

Overview

Synthetix is an early DeFi protocol offering unique derivatives and exposure to real-world assets on the blockchain. The project saw a surge in revenue and trading volumes peaking in June 2022, with revenues growing over 3X to 4X over the past 90 days and 180 days respectively.

Synthetix has also seen a significant uptick in fees collected at its peak with almost 100% of fees given back to stakers. On Synthetix mainnet, we can also see the trend of volume movements and fees:

It is unsurprising that Synthetix has also consistently made it into the top 15 projects in terms of fees collected relative to other projects according to Cryptofees. The below section will provide an overview to understand how Synthetix works and its key revenue drivers.

How it works/Design

Synthetix structures a global debt system around the minting of sUSD (stablecoin) and other synthetic assets using SNX as collateral with a current collateralization ratio of up to 400%. Users will be issued debt shares which are recorded in a global debt pool to represent their borrowing and sUSD will be minted by the Synthetix contract and added to the total supply.

Disregarding fees, a user who mints sUSD (stablecoin) can be thought of as placing a bet that the value of other synthetic assets (non-stablecoin) goes down. This in turn reduces the sUSD minter’s debt relative to users who have minted other synthetic assets, thus generating a profit.

To illustrate with an example, suppose that User A mints $1000 of sUSD and User B mints $1000 of sBTC with 400% collateralization ratio (User A & B both stakes $4000 SNX each). The total system debt is now $1000 + $1000 = $2000, with User A and User B both owning 50% of the total debt.

Suppose that BTC price now drops to $500. The total debt of the system is now $1000 + $500 = $1500. User A and User B own 50% of the total debt each = ($1500/2) = $750, that is required to unlock the SNX staked.

As User A holds $1000 sUSD, User A will realize a profit of $250 after unlocking the staked SNX. As User B holds $500 worth of BTC, User B will realize a loss of $250 to unlock the staked SNX.

In sum, the global debt system favors sUSD when prices of other synthetics (non-stablecoin) falls, and vice versa.

SNX stakers act as a counterparty to the global debt pool and 100% of Synthetix fees are accrued to stakers as staking rewards. This includes trading fees, liquidation fees, interest fees and trading losses made by traders.

The staking rewards can only be manually claimed on a weekly basis by users with a collateralization ratio higher than 400% and are prorated according to the user’s active debt. When collateralization falls below 150%, the user will be given 72 hours to reach the 400% target ratio. Self-liquidation will be served a penalty of 20%, and auto-liquidations will be served a penalty of 30%.

Synthetix introduced the atomic exchange function in Q3 2022 and removed restrictions for sUSD to be at the source or destination of trades made. These changes piqued the interest of multiple integrators including 1inch. A combination of Curve’s deep liquidity and Synthetix’s zero-slippage synthetic conversions made routing swaps via Synthetix on 1inch attractive, driving a huge uptake of volume. Other integrations of Synthetic’s synthetic assets include: Kwenta, Lyra, 1inch, Curve and more, potentially generating more fees for the protocol. The merging of debt pools on Optimism and Ethereum also meant deeper liquidity for Synthetix.

For stakers, Synthetix protocol requires an active management of rewards that are claimed on a weekly basis. Aside from monitoring the 400% collateral ratio, users will have to optimize their active debt to receive higher staking rewards. To do so, users will need to monitor SNX prices and the total system debt. This is mitigated by protocols that reduce the burden of active management, and allows the hedging of debt including dHedge , Toros finance and Gelato Network. Read more here.

Additionally, stakers are effectively betting against traders making a profit and any possible exploits by taking a counterparty position to the total system debt. Synthetix has also been distributing inflationary emissions to stakers to encourage borrowing, and historically, there is a likelihood of this to create reflexive downward pressure on prices.

What’s actionable?

• For users who want to be the least impacted by the global debt pool, they may choose to buy dSNX on Synthetix to hedge existing debt.
• For users who are confident of outperforming the global debt pool, there are LP pools for synthetic assets, and trading of synthetic assets can be done on Lyra, Velodrome, and Kwenta

• For users who are confident that the global debt pool will shrink, they are able to mint sUSD and farm sUSD on Velodrome/Curve/Aave pools

  Summary

• SNX stakers are a pooled counterparty to all debts in the system and are awarded staking returns for carrying the counterparty risk
• The total system debt impacts staking returns, and staking returns are made up of fees, including trading fees, trade losses (counterparty to trade made), interest fees and liquidation fees

• Ways to use the Synthetix (non-exhaustive) include hedging debt with dSNX, farming and trading with synthetic assets, and farming with sUSD.

  Kujira

  Overview

  Kujira is a DeFi protocol offering 3 core products:

• BLUE: For dashboards, governance & voting, and minting/staking/swap/bridging
• FIN: CLOB on-chain DEX with 0.075% maker fees and 0.15% taker fees that is lower than most CEX. Built on Cosmos.

• ORCA: Liquidation platform with 0.5% withdrawal fees and 1% liquidation fees. Orca decentralizes the liquidation process by allowing any user to bid on collateral when the collateral is under collateralized.

  Developing a scalable on-chain CLOB has been a challenge for the industry and a few players in the space tackling it include Mango markets (Solana) , dYdX (moving from StarkEx to Cosmos) and Kujira (moved from Terra to its own L1 on Cosmos). Kujira’s FIN is not a forked DEX; the Kujira team has built FIN from the ground up and launched it in July on Cosmos.

  How it works/Design

  Core products

  Kujira’s revenue is driven mainly by FIN (DEX) fees currently with more value capture expected from ORCA (liquidation platform) and sharing of network fees by other protocol integrations over time. Integrations include projects such as Blackwhale (market-making), Kado (on-ramp), Local money (on-ramp), calc finance (dollar cost averaging feature) and Kujira’s accelerator. With features such as Margin trading on FIN upcoming, Kujira’s revenue is expected to increase as the Cosmos ecosystem is lacking such perp features.

  KUJI Stakers & USK

  Fees collected by Kujira accrues to KUJI stakers. KUJI and ATOM can also act as collateral for Kujira’s USK stablecoin that went live on September 12th, 2022. This overcollateralized model can be done up to 60% LTV, and with a 0.5% mint fee and 5% borrowing APR. The demand for USK is not high currently as the opportunity cost is not justified. ATOM for instance is yielding 10-20%, and this yield is forfeited when minting USK. It can be interesting to look at how USK plays out. In particular, minting USK will add significant utility to collateral that are enabled for liquid staking (e.g. ATOM) and is worth keeping a lookout for.

  What’s Actionable?

  The Kujira team is looking to offer perp trading soon which can be interesting as fees are significantly lower than CEX. However, Kujira has grown its TVL from $900K to $2.7m only since its launch on Cosmos in July, and liquidity pools may not be sufficiently deep for large-sized trades. The USK stablecoin is also interesting to look out for if liquid staking is enabled for ATOM. Summary

• Kujira is an on-chain CLOB DEX built on Cosmos with three core products: BLUE (Kujira dashboards), FIN (CLOB DEX) & ORCA (Liquidation Platform)
• Kujira’s overcollateralized USK stablecoin went live in September which will add significant utility to collateral such as ATOM if liquid staking is enabled on the collateral in the future
• Aside from building key features such as perp trading on Cosmos, Kujira is also building an ecosystem of dapps on its appchain for network fees and revenue sharing. These fees accrue to KUJI stakers. There are also no plans for inflationary emissions to drive demand.

• The growth trajectory of Kujira’s volume and transactions on IBC map of zones looks to be very healthy

  Opyn

  Overview

  Opyn and Paradigm research introduced power perpetuals in DeFi. Opyn resolves the problem of fragmented liquidity with options by consolidating liquidity into a single product where there are no multiple permutations of strike prices, expiry dates and roll overs present in individual options. Opyn’s power perpetual is a derivative indexed to the power of the price of an underlying asset and generates positive convexity/positive gamma for users. This is illustrated in the below payoff profile chart:

  

  An asymmetrical payout profile can be seen from the payout chart. When the price of ETH goes up, holding Squeeth allows the user to have higher returns than a 2X leverage. If the price of ETH goes down, the user makes a loss that is less than a 2X leverage.

  How it works

  Opyn has two core products: the “Squeeth” or oSQTH (ETH power perpetual), and the “Crab strategy”. oSQTH is valued at approximately 1/10 000 of a Squeeth.

  Squeeth As shown in the overview section, Squeeth enables an asymmetrical payoff profile, where holding Squeeth enables an upside of (ETH price)^2 with limited downside compared to a 2X leverage long, and no liquidation risk. To achieve this asymmetrical payoff profile, users taking a long Squeeth position generally must pay a high funding rate via a normalization factor and in-kind funding where the contract continuously change to reflect the funding rate.

  On the other end, users holding the short position puts down ETH as collateral to mint & sell oSQTH and generally receives high funding rate fees for taking the position. Funding fees depend on implied volatility. Additionally short positions also risk being liquidated.

  oSQTH price is dependent on 3 factors: the funding rate (in-kind funding), ETH price, and implied volatility.

  Read more here for details on normalization factor & in-kind funding: Friktion

  Read more here for details on in-kind funding & implied volatility: Joseph Clark

  Due to generally high funding rates, oSQTH buyers will want prices to be volatile over a shorter time frame.

  Crab strategy

  The Crab strategy on Opyn is essentially a short squeeth position that yields attractive high funding fees, with exposure risk hedged by going long ETH at the same time. The result is to earn high yields from funding while being delta neutral, meaning that there will be no liquidations no matter ETH’s price direction. For the Crab strategy to be profitable, ETH price has to stay within X% change from its last price for each price rebalancing that happens every Monday, Wednesday & Friday. Read more about price rebalancing for neutral exposure here.

  https://medium.com/opyn/automated-squeeth-strategies-the-crab-strategy-is-now-live-b92281ebe701

  What’s actionable

  Strats: when do you go long or short squeeth?

Long Users can take a long position when you expect ETH to go up in the short term. As funding rates are high, holding the position over a longer time frame is generally not preferred.

Short Users can take a short position when they expect ETH to trade sideways, and the market is overpricing volatility (short volatility position). Short traders profit when realized volatility is less than the implied volatility. The position would stay profitable if the cumulative funding received exceeds the daily volatility of ETH price movements (squared). Shorters will additionally need to monitor collateral health closely to avoid liquidation.

Summary:

• Opyn has two core products: The Squeeth (ETH^2) and the Crab strategy
• Long positions pay short positions a funding rate
• Long positions pay short positions exchange implied vol

• Returns are determined by the price of ETH, volatility of ETH and the funding rate

  dYdX

  Overview

  dYdX is a decentralized exchange focusing mainly on perpetuals but also offers margin trading, spot trading as well as borrowing and lending. dYdX v3 leverages a hybrid infrastructure where a database of signed messages is maintained by a central frontend service and matched with an orderbook off chain. This allows dYdX to offer trading experience close to a centralized exchange (processes ~1000 orders/cancellations per second) while still retaining properties of a non-custodial protocol.

  How it works

  dYdX enables perpetual, margin, and spot trading along with lending and borrowing. The protocol only accepts USDC as collateral for stability. Users may still deposit non-USDC assets, however, it will be automatically converted to USDC. After depositing USDC, users may take up to 20X leverage for BTC and ETH, and 10X leverage for other markets.

  dYdX utilizes Chainlink’s oracle system for their price feeds and to determine the collateralisation of the account and any liquidations. Similarly to any centralized exchange, if the total value falls below the maintenance margin requirement, the positions will be automatically closed by the liquidation engine. Profits and losses from liquidation are then taken on by the insurance fund. This acts as a backstop to maintain solvency of the system when the account has a negative balance during liquidation. For now, the insurance fund is handled directly by the dYdX team.

  dYdX uses an order book system instead of AMM, and this reduces the risk of slippage. However, this also means a reliance on professional market makers. dYdX uses the Liquidity Staking Pools as interest free, uncollateralized credit lines for market makers to be used solely on the protocol. Market makers using this as a line of credit, could immediately add liquidity across multiple markets on the exchange. Traders, in turn, will benefit from tighter spreads and more depth across all markets.

  Recent Updates

  dYdX is currently running a v3 version that leverages a hybrid infrastructure. With big plans to fully decentralize the protocol by Q4 2022, dYdX V4 will be developed as a standalone Cosmos-based blockchain. With V4, no central party will be able to manage market creation or receive trade commissions. Testnet for dYdX V4 is expected to launch EOY, with a live release in Q1 2023.

  What’s actionable?

• The dYdX team is looking for prospective validators and collaboration for dYdX chain in V4. Validators for testnet EOY, info TBA
• Validators testnet interest form can be found here Summary
• Orderbook system will be shifted to dYdX chain on Cosmos in V4
• Timeline of dYdX chain testnet EOY 2022

• Validator testnet details to be announced, and interest registration has opened. More details can be found here

  Upcoming in Q4: Primitive

Primitive is a unique decentralized exchange built on research published by Bain Capital’s head of research, Guillermo Angeris, Gauntlet Network’s founder, Tarun Chitra, and researcher at Bain Capital, Alex Evans. The core product of Primitive is the Replicating Market Makers (RMMs) that demonstrates the ability to replicate nonlinear payoffs for LPs (so long as they fit certain mathematical constraints), in contrast to Uniswap’s 0.03% payoff.

The Primitive team will be coming onto Alpha discord on 5 Oct to run through how the RMM model works. Primitive is in its early stages and had series A raised only so far from Bain Capital Crypto.

Users can sign up for early access only at this stage on Primitive’s website: https://primitive.xyz/

Conclusion

Innovation in the DeFi Derivatives Landscape is happening at an explosive pace and rightfully so given the huge TAM potential. There are many things to get right, and many protocols are in an experimental stage. There are inherent contract risks for DeFi as well, as seen from the recent GMX and Wintermute hacks so it remains crucial to to size and manage risks accordingly.

We’ve covered in this report a Q3 2022 Derivative Landscape & Alpha Derivatives AMA Round Up. If there are any projects you’d like to have on for an AMA for a deep dive, please reach out to us or share them in the #research-request channel on Alpha discord!