Understanding Binance's launch of Perpetual today: Using virtualization to solve impermanent loss for market makers

This article was published on Mars Finance, authored by Liang Yushan.

For market makers and traders using DEXs (based on the AMM model), impermanent loss and high slippage are unavoidable pain points. DEXs that emerged after Uniswap have thus made solving these two major issues their primary breakthrough.

Currently, most DEXs attempt to reduce impermanent loss and lower slippage by introducing oracles. However, the results so far have not proven that oracles alone can completely resolve the issues—once a hacker attack occurs or the oracle fails, the problems still exist.

Are there other methods that can be tried?

Perpetual Protocol has designed a completely different path: eliminating the order makers (no market makers), leaving only the order takers (traders), to fundamentally reduce impermanent loss and slippage. At the same time, it also attempts to address the long-standing issue troubling retail investors: high Gas fees.

How can asset liquidity be achieved without market makers? How can Gas fees be reduced? The Mars Finance APP will take you through the DeFi derivatives platform Perpetual Protocol, which is favored by institutions such as Multicoin Capital, Three Arrows Capital, Alameda Research, and Binance, from the perspectives of operational mechanisms and development potential.

1. What is Perpetual Protocol?

Perpetual Protocol is a decentralized perpetual contract trading platform that launched its mainnet in mid-December last year (as of now, trading volume has exceeded $1.2 billion), supporting trading of BTC and ETH perpetual contracts, with a maximum leverage of up to 12 times, and is referred to as a combination of Uniswap and BitMEX.

It is well-known that Uniswap is the leading spot trading platform in the DEX market, while BitMEX is a pioneer in the perpetual contract sector of the CEX market. Defining Perpetual as a combination of Uniswap and BitMEX is because the former exists in a decentralized world and primarily provides perpetual contract trading services, right?

Clearly not. So how should we correctly understand the statement "Uniswap + BitMEX = Perpetual"?

It is evident that defining Perpetual in terms of BitMEX is mainly because it is one of the few perpetual contract trading platforms in the DeFi market. The label of Uniswap is applied because Perpetual has designed the vAMM (virtual automated market maker) model, which attempts to address the long-criticized issues of impermanent loss and high slippage that plague AMMs, and this has become its biggest highlight.

To understand Perpetual, one must mention vAMM.

2. vAMM (Virtual Automated Market Maker)

We know that last summer, Uniswap's success pushed AMM (automated market maker) to new heights, and most DEXs that followed also adopted the constant product formula x * y = k (a type of constant product market maker, AMM model) for token exchanges.

Compared to AMM, the vAMM designed by Perpetual is called a virtual automated market maker. Although this model uses the same constant product formula as Uniswap, the two are fundamentally different:

1. vAMM itself does not store a real liquidity pool (k); the real assets are actually stored in the smart contract treasury, which manages all collateral supporting vAMM;

2. vAMM essentially serves as a price discovery mechanism and is not used for spot trading;

3. In the constant product formula (x * y = k) designed by Perpetual, the K value is manually set and adjusted by the development team at this stage, and will later be set by an algorithm.

Unlike traditional AMMs that require liquidity providers to supply liquidity to the liquidity pool, the liquidity of vAMM comes directly from the smart contract treasury outside of vAMM. Therefore, the Perpetual team points out that vAMM does not require liquidity providers to bring liquidity; traders themselves can provide liquidity to each other.

"Since there is no need for liquidity providers in vAMM, the issue of impermanent loss does not exist from the very beginning."

In terms of reducing slippage, in the traditional AMM model, as the size of the liquidity pool increases (the higher the K value), traders face less slippage. This point, vAMM is similar to AMM: as the K value increases, slippage decreases. However, the K value in vAMM is virtual, manually set by the development team at launch, and can later be adjusted algorithmically based on trading volume, open interest rates, financing rates, and other market data.

3. Operational Mechanism

The process of Perpetual is basically similar to that of centralized derivatives exchanges, with the key difference being: in Perpetual trading, the counterparty for traders is the vAMM itself; in centralized platforms, the counterparty is the order maker on the order book.

Before understanding the operational mechanism of Perpetual, we need to clarify one point: the creators need to set the amount of virtual assets stored in vAMM, which is equivalent to synthetic assets, while the real assets are actually stored in the smart contract treasury.

Assuming the token pair in vAMM is vETH and vDAI, with an initial asset amount of 100 vETH and 40,000 vDAI. Trader Alice chooses to go long, while Bob goes short. The operation of Perpetual proceeds as follows:

1. Long Trader Alice

1) Alice chooses to use 100 DAI as collateral to go long on ETH with 10x leverage;

2) Alice deposits 100 DAI into the smart contract treasury of the Perpetual protocol;

3) The Perpetual protocol records 1000 vDAI (10x leverage of 100 DAI) from Alice, and vAMM calculates the amount of vETH Alice receives based on the constant product function (x * y = k);

4) The Perpetual protocol records that Alice now has 2.4390244 vETH, while the amount in vAMM changes to 97.5609756 vETH and 41,000 vDAI.

2. Short Trader Bob

1) Bob then chooses to use 100 DAI as collateral to go short on ETH with 10x leverage;

2) Bob also deposits 100 DAI into the same treasury;

3) The Perpetual protocol records -1000 vDAI from Bob in vAMM, and vAMM calculates the amount of negative vETH Bob receives based on the constant product function (x * y = k);

4) The Perpetual protocol records that Bob is short 2.4390244 vETH, and the assets in vAMM now amount to 100 vETH and 40,000 vDAI.

In this process, vAMM essentially acts as a "bookkeeper," while the smart contract treasury is the actual storage place for the assets. The assets stored in vAMM are synthetic assets, while the real assets are in the treasury.

According to the operational mechanism of Perpetual, it uses the same financing rate formula as FTX to balance longs and shorts. Additionally, the platform provides an insurance fund (50% of trading fees go to the insurance fund, which has already received nearly 500,000 transaction fees), to ensure that successful traders can profit.

FTX financing payment formula

Generally, the funds in the insurance fund will be used to cover two types of losses that occur in the protocol: first, if the liquidator fails to timely liquidate uncollateralized positions; second, if the market is unbalanced, and vAMM needs to pay funding fees. When the assets in the fund are insufficient to cover the losses, Perpetual will mint PERP tokens and sell them on the market to repay the debt.

4. Value Capture of PERP Tokens

PERP is the native token of Perpetual, with three functions:

1. Governance

PERP holders can govern the entire protocol, managing parameters including trading fees, asset listings, and insurance fund management;

2. Staking

PERP holders can stake their tokens in the Staking pool to earn transaction fee rewards and staking incentives;

3. Protection

In extreme cases where the insurance fund is exhausted, PERP holders will act as the final backstop. If this occurs, Perpetual will mint new PERP tokens and auction them, with the proceeds going to the winning traders.

The total supply of PERP is 150 million tokens, with the distribution as follows:

1. 7.5 million PERP: for the Balancer LBP liquidity bootstrapping pool;

Note: The liquidity bootstrapping pool is a type of smart pool whose mechanism gradually changes the weight of tokens in the pool over time.

2. 36 million PERP: allocated to the team and advisors (tokens will be distributed 6 months after the mainnet launch, and subsequently distributed quarterly over the next 30 months);

3. 6.25 million PERP: allocated to seed round investors (Binance invested in Perpetual around 2018);

4. 22.5 million PERP: allocated to strategic investors (tokens for seed and strategic investors will begin to be issued after 25% of the Balancer LBP liquidity bootstrapping pool is completed, and will be issued quarterly over the next 12 months);

5. 77.75 million PERP: for the ecosystem and rewards, incentivizing traders, stakeholders, and developers to build the ecosystem.

According to Debank data, as of February 6, the total locked value of the Perpetual protocol has exceeded 21 million, with a growth of 269% in nearly a month.

In terms of trading volume, Perpetual's trading volume in the past 7 days has exceeded $210 million, surpassing the leading project in the synthetic asset sector, Synthetix ($200 million).

Trading volume ranking of DEXs in the past 7 days

Perpetual's trading volume in the past 7 days

In terms of tokens, the current circulating supply of PERP is 21,801,250 (total supply 150,000,000), with a price increase of 355% in the past 30 days, approximately $7.5 per token, and a market cap of $165,498,864, with 3,612 token holders.

5. Conclusion

In addition to focusing on reducing impermanent loss and slippage through the vAMM model, Perpetual is also addressing the long-standing issue of high Gas fees for retail investors by launching the xDAI sidechain (Layer 2 solution) to cover Gas costs for platform traders.

According to an article released by Perpetual's official account in mid-January, the protocol executed 179,000 transactions for only $183, as the Gas fees on xDai are only 1% of those on the Ethereum mainnet.

Overall, Perpetual has been focused on solving the main issues in the DeFi market, and it is still in the early stages of development, making it worth paying attention to.

References:

1. "A Deep Dive into our Virtual AMM (vAMM)"

2. "An Overview of Perpetual Contract Protocol"