Multicoin: A Brief Overview of How the DeFi Perpetual Contract Protocol Perpetual Protocol Works

This article was published on ChainNews, authored by Kyle Samani, Managing Partner at Multicoin Capital.

There is a long-standing joke that all financial innovations can be boiled down to two points: finding ways to increase leverage and bundling/splitting risks to allow investors to price assets more effectively.

The first major financial innovation dates back to the separation of debt and equity in the 15th century. It split risks and created two types of risk holders: debt (low risk, low return) and equity (high risk, high return).

The pace of development in financial markets has increased a thousandfold over the past 20 years, but the overall financial structure has remained largely unchanged. Most capital flows are still limited to: debt, equity, preferred stock, futures, and options.

The emergence of securitization has improved the overall efficiency of large-scale capital allocation, but the vast majority of underlying assets that have been securitized have not undergone substantial changes. The same is true for financial structures: the large banks providing these complex products primarily use the aforementioned popular tools to hedge potential risks.

In terms of new financial structures, credit default swaps (CDS) and collateralized debt obligations (CDO) have developed rapidly over the past 20 years. They can both split risks, allowing investors to price assets more effectively based on collateral and potential capital costs.

In the crypto industry, the DeFi ecosystem is experimenting with new financial structures at an astonishing speed. For example, a plethora of tools based on liquidity pool market makers have emerged in a Cambrian explosion, including options (like Hegic, Potion) and spot trading (like Uniswap, Balancer, Curve).

However, the most significant financial innovation in the past decade is the "perpetual swap contract" launched by BitMEX in 2016, also known as "perpetual contracts." Many current financial structures in the market focus on trading synthetic assets, but we believe that perpetual contracts are at the forefront of the correct architecture. This is also evident empirically. At this stage, the trading volume of cryptocurrency contracts is 3-10 times that of spot trading, while the trading volume of other synthetic assets only accounts for a portion of spot trading. The market has become very clear: relative to synthetic asset trading, perpetual contracts represent the ideal financial structure. We also expect perpetual swap contracts to become a very popular asset class in the next decade.

Therefore, as early as August 2020, we led a $1.8 million investment round in the new automated market maker (AMM) protocol focused on perpetual contracts, Perpetual Protocol (also known as Perp.fi)!

Among the participants were partners from Alameda Research, Three Arrows Capital, CMS Holdings, Zee Prime Capital, and Binance Labs, as well as well-known cryptocurrency angel investors Alex Pack, Andrew Kang, Tony Sheng, Calvin Liu, George Lambeth, and Regan Bozman.

Since then, the team's progress has been very good. A month ago, Perp.fi officially launched, and its trading volume over the past week reached $304 million, making it the sixth largest decentralized exchange on Ethereum at the time of writing. Today, they just released a blog that provides a comprehensive review of the achievements made since the mainnet launch a month ago. To explore the reasons behind Perp.fi's rapid growth, it is necessary to analyze its architecture and team closely.

About Perpetual Protocol

Perp.fi is a groundbreaking financial facility that combines the advantages of CeFi and DeFi: the CeFi-style leverage that perpetual contract traders expect, along with the liquidity and simplicity provided by the DeFi system's AMM.

Traditional AMMs have some drawbacks, the most prominent being the impermanent loss faced by market makers and low capital efficiency. Perp.fi fundamentally addresses these two issues by eliminating the order book side. There is only the taker side in Perp.fi!

So how does it work? The Perp.fi team's blog provides a detailed explanation, and here is a brief summary.

Perp.fi is powered by a virtual automated market maker (vAMM). Before trading with the vAMM, traders need to deposit collateral into a vault, a step similar to other derivatives exchanges (initially supporting only USDC, with other collateral types potentially introduced later). After depositing collateral, they can trade perpetual contracts just like on centralized exchanges, with one key difference: on centralized exchanges, the counterparty for traders is the order book's maker, while on Perp.fi, the traders' counterparty is the vAMM itself. Perp.fi's vAMM uses the same xy = k curve as Uniswap.

Since the vAMM is virtual, the k value is also virtual—this means it can be algorithmically adjusted based on trading volume, open interest, funding rates, and other market data. As the k value increases, traders experience lower slippage.

Perp.fi offers all the features found on other perpetual contract platforms, balancing longs and shorts through a funding rate. The V1 version uses Chainlink as a price oracle to provide a reference index. The funding rate formula is the same as that of the FTX exchange. Perp.fi also has an insurance fund to ensure that successful traders can realize profits.

Perp.fi is driven by a token called PERP. The PERP token has several functions. First, PERP holders govern the entire protocol, managing parameters such as trading fees, asset listings, and insurance fund management. Second, in extreme cases where the insurance fund is depleted, PERP holders will act as the ultimate backstop. If this occurs, the protocol will mint new PERP tokens and auction them off, with the proceeds going to the winning traders.

The founders of Perp.fi, Yenwen Feng and Shao-Kang Lee, are serial entrepreneurs who have founded seven companies over the past 15 years. Before the advent of the iPhone, they were pioneers in mobile app development, creating early real-time social and mobile experiences, and have recently delved deeply into the crypto space for several years. Due to their obsession with financial engineering and the design principles of derivatives, they realized the possibility of developing perpetual contracts based on the vAMM curve after studying the complexities of DeFi.

Over the past few months, I have been closely collaborating with the Perp.fi team and found them to be very humble and hardworking. They have assembled an excellent team and attracted numerous investors and advisors. Along the way, they have been pragmatic and thoughtful at every stage, executing very smoothly.

The greatest advantage of the Perpetual Protocol may be its ability to trade any asset with a public price, meaning it can trade perpetual contracts for cryptocurrencies, commodities, and/or any category of assets. Thanks to its permissionless and censorship-resistant nature, Perp.fi will benefit billions of people worldwide, democratizing access to financial markets and allowing them to enjoy the liquidity it provides. We are incredibly excited to be a part of this.

Disclosure: Multicoin has established, maintained, and enforced reasonably designed written policies and procedures to identify and effectively manage conflicts of interest related to its investment activities. Multicoin Capital adheres to a "no trading policy" for three days following the public release of this report. Multicoin Capital is an investor in the Perpetual Protocol and holds PERP tokens.

Source link: multicoin.capital