Dialogue between Synthetix and Perpetual: Structured and Aggregated Products May Be the Future of the Derivatives Track

Recently, the 23rd session of the Catcher Academy, hosted by Chain Catcher, invited Dorothy, the head of Synthetix Greater China, and Nigel, the head of Perpetual Protocol China, to share insights on "Why Derivatives Are the Most Promising DeFi Track This Year."

During the session, Dorothy and Nigel shared with community users the main development obstacles currently facing decentralized derivatives, issues with AMM mechanism design, solutions, and the risks that ordinary people need to be aware of when participating in DeFi derivatives mining. The full text is organized below, hoping to inspire readers.

Chain Catcher: Could you both briefly introduce the positioning of Synthetix and Perpetual, as well as your specific explorations and advantages in the DeFi field?

Dorothy: Synthetix is a decentralized synthetic asset (Synths) protocol built on Ethereum. Users can mint stablecoins like sUSD by staking our token SNX or directly purchase sUSD to trade synthetic assets such as cryptocurrencies, foreign exchange, stocks, commodities, indices, and inverse assets on our platform.

In the blockchain world, we do not have effective ways to trade traditional assets like stocks directly, so we need to synthesize virtual assets on-chain by anchoring the prices of traditional assets for trading.

Simply put, synthetic assets are mirror simulations of target assets. For example, sUSD is pegged to the US dollar, sGold is pegged to the price of gold, sTSLA is pegged to Tesla's stock price, and sDeFi is pegged to the DeFi index. By mapping real-world assets, everything can be traded on-chain.

Founded in 2017, Synthetix is one of the earliest projects in the industry to attempt decentralized synthetic asset issuance and trading mechanisms, boasting advantages such as no slippage, infinite liquidity, and a rich asset portfolio, making it one of the leading projects in the DeFi world.

Next, we will deploy the protocol on the Optimism Layer 2 network and launch the V3 upgrade, which will include futures functionality.

Nigel: Perpetual Protocol, as the name suggests, is a perpetual protocol based on vAMM on-chain derivatives. Our main product is perpetual contracts.

We were the first project to conduct token LBP sales on Balancer, and after more than half a year, it has become a relatively mainstream method for IDOs. Additionally, our mechanism is vAMM, which is the first to introduce AMM into derivatives trading, attracting a lot of attention from DeFi enthusiasts.

In terms of advantages, I believe we have a first-mover advantage because there are few on-chain perpetual contract trading platforms with low fees and significant user and trading volumes besides Perpetual. We have also developed on xDai, which means lower fees and a much better user experience compared to Layer 1 networks.

Chain Catcher: The heat of DeFi has persisted for almost a year, and products in various sectors have matured, especially in the derivatives track, where many investment institutions are laying out their strategies. As early participants, what do you think is the current development stage of the DeFi derivatives track?

Dorothy: First, let me share the definition of derivatives. Derivatives are financial contracts whose value depends on one or more underlying assets or indices, including forwards, futures, swaps, and options. They can be standardized or non-standardized, primarily used for hedging, speculation, and arbitrage.

In the digital asset space, futures are linear contracts, and the products are relatively simple, experiencing explosive growth two years ago. Options, on the other hand, are very complex derivatives with high entry barriers, and only last year, with more institutions entering the market, did they begin to see exponential growth.

Early leading centralized futures exchanges included BitMEX and OKEx, while recently Binance, Huobi, and FTX have surpassed them in trading volume, becoming the new leaders. For traditional compliant institutions, CME is the go-to choice; in the less mature options track, Deribit has long been the standout.

In the decentralized space, Synthetix is the leader in synthetic assets. We support spot trading of synthetic and inverse synthetic assets, as well as binary options trading, and will support futures trading after launching on Layer 2.

Among decentralized exchanges focused on futures, dYdX is the oldest project, while Perpetual Protocol, Ddx, Injective, and Mcdex are all emerging stars from last year. Hegic and Opyn are new projects in the options space.

The derivatives track is still in a relatively early stage, with trading volumes still very small compared to centralized exchanges. There are more entrepreneurial projects in the futures space, but no clear leading project has emerged yet, and the options space is even more challenging to promote and popularize due to the complexity of options themselves.

Nigel: Compared to the tenfold difference in trading volumes between derivatives and spot trading in centralized systems, I believe the explosion of DeFi derivatives is still far from happening. The perpetual protocol is currently scaling, but daily trading volume is only around $50 million to $60 million, while Uniswap's recent trading volume exceeds $1 billion.

The disparity in trading volumes between on-chain derivatives and centralized derivatives is at least a hundredfold. Therefore, we cannot even assign a recognizable name to the current stage. I coined a term called the "cocoon period," where the entire track is doing addition, trying, failing, and wasting. Don't be afraid to feel trapped; it requires encouragement for a period.

Chain Catcher: In traditional finance, the volume of derivatives far exceeds that of spot trading, but in the DeFi space, the trading volume of derivatives still accounts for a very low proportion of the total trading volume of crypto assets. Many practitioners believe that decentralized derivatives still have significant room for development. How large do you think the potential market space for decentralized derivatives is? What are the main development obstacles currently?

Nigel: I think there is at least a hundredfold space. The current obstacles mainly come from the following points:

DeFi users are still too few. Most of the current educated DeFi retail users are here to participate in mining for profits or have come to trade on-chain due to better liquidity and depth in DEX, and they do not have a habit of using derivatives.

The solution to the previous question is that projects need to continuously attract users. However, users who are attracted find that network fees are high and slow, and more importantly, the depth of on-chain derivatives is also poor. So the second obstacle is insufficient infrastructure and fragmented product capabilities.

Dorothy: We can look at a set of data. In the traditional financial market, the total market capitalization of stocks is $70 trillion, the bond market is even larger at $130 trillion, and the derivatives market's market capitalization exceeds the sum of both, reaching $1 quadrillion. This shows that the derivatives market is significantly larger than the underlying asset market.

In comparison, in our industry’s centralized exchanges, the trading volume of digital asset derivatives is only three times that of the spot market. We can expect that within two to three years, the derivatives market can further grow and far surpass the spot market, reaching ten times the size of the spot market.

With breakthroughs still needed in the centralized market, the decentralized derivatives market is currently in a very early stage, primarily catering to early DeFi "farmers" and experts, and cannot yet accommodate large institutional funds for trading.

I believe the main obstacles currently come from three aspects. The first is market education; many derivatives users are accustomed to trading on centralized exchanges and are not familiar with or do not trust DeFi products. Especially in extreme market conditions, top centralized exchanges like Binance have stronger solvency, while decentralized exchanges can only rely on insurance funds and the cash reserves of foundations, raising doubts about their solvency.

The second is the issue of trading costs. Derivatives exchanges are inherently more complex in smart contract design than spot exchanges like Uniswap. Additionally, derivatives traders trade more frequently and are more sensitive to execution prices and trading costs, which affects the overall experience. Currently, many products on Ethereum are constrained by the Ethereum network, facing high network fees, delayed and costly oracle price feeds, and severe price slippage.

Finally, and most critically, is the issue of liquidity. Centralized exchanges complete matching through order books, where users act as counterparties to each other. Without market makers, it is challenging to efficiently match orders based solely on fragmented buy and sell demands from users. In decentralized exchanges, on-chain efficiency is low, and market makers find it difficult to control trading costs, making it hard to provide liquidity, which in turn makes it difficult for users to complete trades at ideal prices.

To address the liquidity issue, Synthetix created a debt pool mechanism, allowing users to stake funds to create a debt pool that acts as a counterparty, enabling trading with no slippage and infinite liquidity. Perpetual Protocol's vAMM (automated market-making curve) mechanism seems to adopt a similar staking pool concept.

Chain Catcher: What do you think are the conditions needed for decentralized derivatives on DeFi to reach the scale of derivatives markets on CEX? What would be the triggering points?

Nigel: First is infrastructure, including network performance, network fees, etc. Secondly, the industry development stage needs to reach a level where people's on-chain behavior frequency increases by another order of magnitude, of course, relying on the above conditions. Third is product stratification; a single standout is not enough; there must be various players targeting large whales, serving retail users, focusing on forward contracts, and targeting perpetual contracts, with enough people and teams in each category to experiment and iterate.

As for triggering points, I think market FOMO is relatively easy; hot topics rotate, and after Layer 2 emerges, people will naturally assume it’s fine and hype it up. However, I believe the real trigger is when something transitions from being highly sought after to becoming commonplace, such as leading DeFi protocols like Uniswap and Synthetix. Therefore, although the perpetual protocol is part of this track, I do not expect derivatives to explode in the short term.

Dorothy: I believe Ethereum L2 (Layer 2 network) will be an important opportunity for derivatives DEXs in terms of both token prices and practicality. For example, dYdX has chosen to collaborate with StarkWare, which supports ZkRollup technology, and has already launched its L2 version.

Synthetix, along with Uniswap and Chainlink, is an early supporter of the Optimism network, and we expect to launch L2 trading functionality this month. Network fees are currently a major issue restricting all Ethereum ecosystem projects. On Layer 2, trading can reduce network fees by at least 90%, meet faster transaction times, and effectively reduce slippage issues.

However, I do not believe that DEXs will catch up to CEXs in terms of trading volume for derivatives in the short term. Even on Layer 2, decentralized exchanges still lag behind centralized exchanges in user experience and trading costs. Of course, the relative success of decentralized exchanges can force centralized exchanges to improve issues like slippage, downtime, and liquidation. Meanwhile, centralized exchanges further educate the market and expand the user base, which can bring more fresh blood to decentralized exchanges.

Chain Catcher: From the experience of traditional finance and centralized exchanges, acquiring customers for derivatives remains a challenge. What do you think is the key to attracting users to on-chain derivatives exchanges? What risks should ordinary people be aware of when participating in DeFi derivatives mining?

Dorothy: Centralized exchanges generally attract market makers to provide liquidity through fee rebates and offer trading fee discounts to ordinary users through VIP tier systems. Currently, the most common way for decentralized exchanges to attract new users is through liquidity mining.

Synthetix adopts a staking mining model. To encourage users to stake and trade on our platform, we launched an inflationary monetary policy in April 2019, stipulating that a certain percentage of SNX tokens would be issued each year over five years, gradually decreasing, with an initial inflation rate of 75% and this year's inflation rate being around 29%.

Users can stake our token SNX to mint stablecoin sUSD, with a staking rate of 500% required on the Ethereum Layer 1 network, meaning that to mint $1 worth of sUSD, users need to stake $5 worth of SNX. When the staking rate falls below 500%, users need to burn their sUSD to raise the staking rate back to 500%.

On the already deployed Layer 2 network (currently only supporting staking minting and receiving staking rewards), the required staking rate to maintain positions is 600%.

When the staking rate drops to 200%, users have three days to top up by burning sUSD to raise the staking rate. If users fail to complete the top-up within the three-day validity period, the portion of the staking rate that falls below 500% (600% for Layer 2) will be liquidated to restore the staking rate to 500%. This mechanism provides users with ample buffer time to avoid forced liquidation risks on-chain and protect their positions.

Some platforms adopt a trading mining model, like MCDEX, where perpetual contracts are directional trades. The platform provides users with automatic hedging tools, and users need to periodically rebalance.

Overall, participating in DeFi derivatives mining requires prior investigation into the security of the platform's smart contracts (e.g., whether they have undergone security audits, whether there are backdoors) and the reliability of the platform's qualifications (e.g., team background, institutional endorsements). Mining often carries impermanent loss or liquidation risks, so users must thoroughly understand the platform's operational rules and prioritize risk management.

Nigel: I think the most important factor is product maturity. The reason OKEx was able to dominate the delivery futures contracts market previously was due to its strong product capabilities. Similarly, BitMEX's rise in 2018 was also due to its promotion of perpetual contracts. Under the condition that all infrastructure is mature, it is essential to innovate with a mindset and endure the time when no one is paying attention to polish truly powerful on-chain derivatives.

I believe that when it comes to DeFi derivatives mining, one must pay attention to security risks, as opportunities are not scarce, but capital is. Mining itself is mostly driven by the project's demand for liquidity, incentivizing users to inject liquidity with tokens. I think pursuing profit is natural; after all, no one can escape this in the market. However, if everyone is willing to spend a little time thinking about the value of the protocol and the value of providing liquidity, and to understand it before acting, they may gain some spiritual satisfaction beyond just making money.

Chain Catcher: We all know that the emergence of AMM is crucial for the development of DeFi, but recently, the issues of impermanent loss and capital utilization rates related to AMM have been a focus of the industry. Could you analyze the problems in the AMM mechanism design of derivatives products and possible solutions from these two issues?

Dorothy: Traditional AMM mechanisms use the formula xy=k, which has the disadvantages of low capital efficiency and high trading slippage. Market makers providing liquidity for trading pools often incur impermanent losses as a result.

As far as I know, most futures exchanges on the market still adopt the order book model, such as dYdX and Ddx, which use off-chain matching and on-chain settlement. The downside of this model is its high degree of centralization; the core parameters of perpetual contracts rely on off-chain facilities, and when the order book fails, the on-chain funding rates cannot be updated. Additionally, other smart contracts cannot interact with off-chain order books to construct other structured products.

Synthetix plans to launch futures products with 10x leverage after officially going live on Layer 2, continuing the debt pool model used in spot trading.

First, let me explain the concept of funding rates. In traditional financial markets, futures contracts naturally converge to spot prices upon expiration. However, perpetual contracts, invented by BitMEX and adopted by most exchanges, do not have an expiration date, so we need to adjust prices through funding rates, where the dominant side (the one making the correct bet) subsidizes the other side to bring the contract price back to the spot price.

On Synthetix, the prices of our synthetic assets are directly generated through Chainlink oracles, and there is no decoupling between contract prices and spot prices. Instead, we also need to adjust funding rates to influence market slopes and reduce risks in the debt pool.

On other trading platforms, every buy order must be matched by a corresponding sell order, so the market is never tilted; the number of contracts traded by longs and shorts is always balanced.

But on Synthetix, each contract trade does not require a counterparty; instead, it is directed at the sUSD debt pool generated by users staking SNX tokens. Here, we need to explain the concept of a floating debt pool.

All SNX holders incur a "debt" when they stake; initially, the debt is equal to the amount of sUSD they initially minted, and afterward, the debt fluctuates based on the profits from other synthetic asset holders trading on the platform.

When someone uses the minted sUSD to purchase other synthetic assets like sBTC, and if sBTC appreciates, that person outperforms the market, causing the overall market's debt pool to increase. This person's profits will proportionally add to the debts of all SNX holders participating in staking. Each holder must repay all sUSD debts to unlock and retrieve their staked SNX (in this case, the final debt of other debtors is higher than the initial minted amount of sUSD).

When a user exchanges sUSD for sBTC, sBTC is essentially created out of thin air, and no one sells it. After the trade is completed, the system automatically destroys sUSD and creates sBTC for the user, increasing the total supply of sBTC in the market, which also increases the total debt of all staked SNX holders. This zero-sum game mechanism provides infinite liquidity to the market.

Now let's look at the application of debt pools in the futures market.

Assuming a one-sided market where 90% of trading users are bullish, and the spot price indeed rises, then users participating in staking must repay a higher debt. Therefore, the bulls must pay a higher funding rate than on other platforms to attract more shorts and reduce the risk for staked users.

Assuming the total value of long positions across the platform is $100,000 and the total value of short positions is $10,000, in this case, the shorts will receive funding fees corresponding to $10,000, while the excess $90,000 in funding fees will be paid to staked users. The purpose of this design is to prevent the market from tilting towards either the bulls or bears, maintaining neutrality to reduce the debt risks faced by staked users. In summary, it uses the funds provided by staked users to act as counterparties for trading users.

Nigel: I have observed several ways to mitigate impermanent loss in AMM-based products:

The first is conscientious projects like ThorChain, which help users solve impermanent loss related to Cover and Rune trading pairs.

The second is to innovate the AMM mechanism, such as DODO's PMM, or simply like us, where Perpetual Protocol does not have real liquidity; all liquidity in the AMM pool is virtual. When users deposit assets, they are essentially not entering a liquidity pool but are separately sealed and waiting for settlement. Based on the leverage ratio set by the user, a corresponding amount of vUSDC is minted into the virtual liquidity pool. The advantage is that users can achieve good trading depth without needing anyone to provide liquidity.

The third is our future solution, which does not target our own AMM but aims to minimally integrate Perpetual Protocol into AMM-based DEXs, allowing users to hedge against impermanent loss caused by providing liquidity with a single click.

At this point, I want to extend this topic: do derivatives really need to rely on liquidity loyalty? Liquidity loyalty is very low; they are profit-driven. For derivatives, which currently do not have that much profit to pursue, how can we mitigate the risks associated with liquidity loyalty?

I believe that Synthetix's synthetic asset approach is very effective; it is a single token that can generate multiple assets. The trading targets and assets on the platform all stem from the SNX source. The mechanism is excellent, and the recently well-performing MIR operates on a similar principle. Another way to mitigate liquidity loyalty risk is to use virtual liquidity to provide services, which can alleviate pressure on both users and project parties, allowing them to please users while retaining liquidity.

Chain Catcher: As a well-known synthetic asset protocol on the Ethereum platform, Synthetix plays a very important role in the DeFi derivatives field, and PERP also adopts the new vAMM mechanism. Could you both discuss what issues in traditional financial derivatives can be better solved through decentralized derivatives? What more exciting applications and expansions can we expect in the future?

Nigel: From the user's perspective, it is permissionless. Traditional derivatives have high leverage and volatility, imposing strict requirements on investors. In other words, there are strict audits, market fragmentation, and limitations in time and physical space. In the on-chain, decentralized world, these limitations may not exist; trading can occur 24/7 without KYC, providing a wonderful experience.

I still look forward to the Lego-like properties of DeFi being presented in derivatives, allowing our solitary derivatives to have better composability and empower the DeFi world.

Dorothy: In traditional financial markets, the markets for different countries and asset categories are often fragmented, and the barriers to market access are very high. However, the Synthetix platform can provide global users with a one-stop trading experience for digital currencies, foreign exchange, stocks, commodities, indices, and inverse assets, available 24/7 without identity restrictions, audits, or barriers. This greatly facilitates cross-asset, cross-market, and cross-position trading management for users. For example, if oil prices plummet one day and the dollar depreciates, you can convert your assets into Bitcoin for hedging.

Another significant advantage of decentralized protocols is community governance. Users can vote to choose the types of assets they wish to trade on the platform, adjust the composition of currencies within indices, and make other important decisions, which is unimaginable in traditional markets.

Non-custodial, no barriers, and anti-censorship are the greatest advantages of decentralized protocols. DeFi protocols can disrupt the existing financial system, becoming a true "digital bank," providing inclusive financial access for billions of people worldwide, especially the new generation of digital natives.

Chain Catcher: The derivatives track features a relatively diverse range of products, including options, futures, prediction markets, synthetic assets, etc. Once the scalability issues of Ethereum are resolved, how will these sub-sectors combine? What kind of competitive landscape will this create in the DeFi track?

Nigel: Once the scalability solutions are excellent, and users and protocols concentrate on one or two scalability solutions, the performance limitations of infrastructure on products will be lifted. I believe that ultimately, there may be a relatively large platform that encompasses all product categories in the derivatives track.

There are two possibilities: one is that protocols with platform potential increase functionality, taking the strengths of each and integrating into a platform with protocol matrix interoperability.

The second possibility is that there will be a relatively macro-oriented middleware platform in the future, encapsulating the necessary infrastructure to attract various categories of derivatives, ultimately becoming an ecological platform. This is my vision for future combinations; simply put, protocols will not be isolated. Based on such a platform, the composability with current mainstream DeFi protocols will also become easier to achieve due to the improved convenience of mutual invocation.

Dorothy: Currently, the largest trading volume in the DeFi market still comes from native digital assets, but the traditional asset market is thousands or tens of thousands of times larger than the entire digital asset market. Therefore, on-chain synthetic assets that map real-world assets will have enormous growth potential in the future wave of digital asset mainstreaming.

What we are currently doing is combining synthetic assets with futures, options, and various derivatives to provide users with a rich variety of trading tools.

Additionally, I am very optimistic about structured products that utilize the composability of smart contracts. In fact, in the DeFi world, the most frequent users of a particular smart contract protocol are not individual users but other smart contracts. Currently, on-chain derivatives structures are relatively simple, and yield aggregators like YFI mainly derive their income from mining on Curve. As the industry's infrastructure matures, more teams will leverage the composability of financial Legos to combine different options and futures contracts, launching on-chain structured products with higher yields and more variety than existing protocols like YFI.