Reviewing the past two years of the DeFi derivatives track from the perspective of market and product logic

Author: Beichen, Chain Teahouse

Friends who are familiar with Chain Teahouse must know that we have been paying close attention to the DeFi field for a long time, especially since two years ago when we were certain that the DeFi derivatives track would definitely explode.

But awkwardly, the DeFi derivatives track only began to truly thrive six months ago, and the projects that emerged were all outside our field of vision… especially since we believe that in terms of DeFi derivatives, they are either not DeFi enough or not derivative enough.

In this process, we have also been constantly reflecting on what the future DeFi derivatives black horse will be.

In addition to being external observers of DeFi derivatives exchanges, we have also engaged in conversations with the actors who have immersed themselves in the field, reviewing the experiences of the past two years together. You can consider this as a reflection based on the logic of the market and products.

I believe that these experiences and lessons, condensed from a large amount of time, energy, passion, and intellect, can serve as a cognitive lever to enhance your understanding of DeFi derivatives.

Starting from Market Logic

In February 2021, DeFi Summer had already passed for more than half a year, and basic financial services like lending and trading had become saturated. The mining frenzy had cooled down, leading hot money to start focusing on the deep waters of finance—derivatives.

At that time, the market logic was that the basic financial modules could fully meet investors' needs, so the rapidly iterating and evolving DeFi would continue to grow and touch upon derivatives, the "pearl on the crown of finance."

Following this logic, Chain Teahouse believed that derivatives are relatively complex, and their DeFi solutions must be provided by teams that understand finance better. We then connected with the Deri Protocol team and have since engaged in ongoing discussions about DeFi derivatives.

However, in the following two years, the market did not develop according to the logic we initially deduced. So where did the problem lie?

Looking back now, the basic logic was sound; the issue was that we overlooked the complex conditions required for the proposition to hold, or perhaps it is clearer to look at it from the other side—why did on-chain derivatives trading not explode immediately in February 2021?

First, the user base for trading was insufficient.

Although Yield Farming brought an unprecedented number of new users to the chain, they were mainly wealth management users attracted by APY, and the actual number of real trading users was quite small (even Uniswap's monthly active users were only 350,000), let alone trading complex derivatives on-chain.

Second, the appeal for liquidity providers was not significant.

At that time, the Yield Farming model centered around releasing platform tokens had already begun to fail, but on-chain derivatives exchanges were just starting to come online. Liquidity providers had already begun to become immune, and algorithmic stablecoins with high APY but possessing a Ponzi-like factor were clearly more attractive at that moment.

Even with hindsight, if we were to return to the situation at that time, besieged by the above two aspects, we still couldn't find the breakthrough point for on-chain derivatives exchanges.

In fact, the subsequent rise of on-chain derivatives exchanges was largely driven by external factors.

The successive explosions of centralized exchanges led many users who originally only engaged in on-chain wealth management to start shifting their trading activities on-chain. Meanwhile, the Real Yield model, which focuses on releasing real returns, gradually emerged, proving to be very attractive for liquidity providers.

Thus, it was reasonable for GMX, which adopted this model earlier, to take off. It can be said that GMX's success is largely not a success of DeFi derivatives, just as the popularity of the Deyun Society does not mean that crosstalk has become popular.

Before the external factors were met, the only thing on-chain derivatives exchanges needed to do was to "survive"—continuously iterating on the product to explore new directions, maintaining interaction within the community to preserve the existing user base and activity, and then simply waiting for the right moment to arrive.

As for the logic of product iteration during this period, the initial thoughts of the Deri Protocol team are also very valuable for reference.

Starting from Product Logic

In 2021, the leading players in the DeFi derivatives track were still dYdX, Perpetual, etc., but they could only be described as on-chain futures exchanges, rather than having all core trading logic conducted within smart contracts like Uniswap.

From the perspective of the Deri Protocol team at that time, a DeFi derivatives exchange should first be DeFi, and secondarily about derivatives. DeFi represents the evolution of finance in terms of trading paradigms and asset conversion efficiency, with Uniswap being the most typical example.

AMM-Based Trading Paradigm

In classical financial exchanges, liquidity providers are designated market makers, who have advantages over ordinary traders (rebates on transaction fees, ultimately leading to negative average trading costs), information advantages (access to deeper order books), and technical advantages (faster access speeds).

Uniswap, on the other hand, directly abandoned the order book-based trading paradigm, adopting an AMM trading paradigm based on liquidity pools, turning market makers into LPs with no barriers to entry. Moreover, the AMM model also aggregated fragmented liquidity, greatly enhancing capital efficiency.

Using Tokens for Asset Conversion

Before the advent of DeFi, conversions between different assets almost entirely relied on cash-like assets (M1) as intermediaries. For instance, converting real estate into stocks would require first selling the property for cash and then using that cash to buy stocks, resulting in significant friction during the conversion process. To improve capital efficiency, leveraging was often employed, which could easily lead to liquidity crises.

However, with the advent of the DeFi era, assets on-chain (even FT and NFT) can be directly swapped without the need for intermediaries.

Thus, the product logic of Deri Protocol can be described as a BitMEX style of Uniswap.

Later, their version iterations either followed the basic logic of DeFi to introduce mechanisms like shared liquidity pools and external liquidity pools, or followed the logic of derivatives to launch perpetual contracts, perpetual options, Power, Gamma, and other types of perpetual derivatives, especially the perpetual options and subsequent derivative types, which were the first to be realized in the financial world.

However, the reality is that during the past six months of rapid advancement in the DeFi derivatives track, Deri Protocol, which continuously iterated along the logic of DeFi and derivatives, did not capture much market share or rank highly in market capitalization…

This was largely because the existing on-chain derivatives market still had relatively simple functions, primarily catering to speculative demands for betting on price movements, and had not yet generated much hedging demand.

To serve more scenarios based on derivatives, a series of professional tools need to be provided; otherwise, only very specialized users can directly use derivatives trading for hedging. Therefore, future derivatives exchanges are likely to introduce a series of derivatives toolkits (for example, various wealth management products after hedging with derivatives).

Conclusion

After two years of development, on-chain derivatives trading has cultivated a considerable number of traders, and since the transaction fees for derivatives trading are higher than those for spot trading, it is also very attractive for liquidity providers. We believe that on-chain derivatives trading will continue to develop in 2023 (including non-DeFi on-chain derivatives trading).

As for DeFi derivatives, they will evolve from a singular trading demand to more diverse demands for hedging and wealth management, just as the traditional financial derivatives market is supported by the substantial hedging demands of large physical industries.

So, two years later, we still have a positive outlook on the DeFi derivatives track, especially on derivatives exchanges that build relatively complex wealth management demands based on fundamental derivatives trading.