ABCDE: Why do we invest in Surf Protocol?

Written by: ABCDE

Surf Protocol, led by ABCDE, is a permissionless AMM derivatives trading protocol that supports the creation and trading of a wide range of crypto assets. To introduce it using a familiar model, Surf is the contract version of UniSwap, with a key innovation: it allows anyone to provide perpetual contracts for any on-chain token without permission. Anyone can create contract pools.

Compared to GMX and dydx, which only have 9 and 37 assets respectively, Surf's advantage lies in its permissionless pool creation, enabling one-click provision of perpetual contracts for any token. In the future, Surf will have thousands of long-tail asset perpetual contract trading pairs.

1. Trader Extractable Value --- Value Extractable by Traders

To understand Surf's key innovation, one must grasp the role of Trader Extractable Value in the AMM derivatives space.

When describing MEV, we often liken blockchain to a dark forest, filled with various bots and scientists seeking potential profit opportunities in the unconfirmed transaction pool (mempool) to arbitrage in various ways, which is the origin of MEV — Maximum Extractable Value.

However, MEV is more inclined towards various arbitrage opportunities in the overall blockchain, such as spot DEX and lending liquidation. In certain niche areas, there are even more refined concepts.

For instance, regarding the reverse selection cost of DEX LP, A16Z published a detailed article on LVR - Relative Loss Rebalancing, which will not be elaborated here. Another example is the arbitrage space created by price differences between spot and derivatives — we call this Trader Extractable Value (TEV).

In simple terms, the price manipulation of Ava on Avalanche that occurred last year with GMX is a typical example of TEV. When the cost of manipulating the spot price is less than the friction cost on the futures side, scientists can profit. You might question that Avax is relatively easy to manipulate due to its own liquidity, but surely BTC and ETH cannot be played this way. That is partly true, but also not entirely.

It is true because the depth and consensus of BTC and ETH make controlling the spot price much more difficult, which is why GMX V1 only had BTC and ETH trading pairs on Arb.

It is not entirely true because GMX's GLP TVL is only a few hundred million. Imagine if GLP's TVL were several billion; under the premise that traders profit while LPs lose when betting against GLP, large players would certainly spend "big money" to manipulate the prices of BTC and ETH, repeating what happened with the AVAX trading pair. As long as GLP's trading depth is sufficient, GMX's fixed trading friction costs will inevitably lead to the cost of spot price manipulation being less than the friction costs of futures. As GLP's TVL increases, the possibility and success rate of TEV also continue to grow, which is why the TVL of GLP is stuck at the "equilibrium state" threshold of a few hundred million dollars.

2. A Trading Protocol Where Anyone Can Open an Exchange - Surf's Solutions and Innovations

How to incentivize a larger TVL for derivatives and create an innovative trading protocol?

Surf's solution is quite straightforward. To maximize LP incentives, Surf has made an interesting innovation in the LP mechanism, creating a B2B2C trading protocol. Generally, LPs earn 70-80% of the trading fees, with 20-30% going to the protocol itself. Surf has made a crucial innovation where 80% of the trading fees go to LPs, 10% to the protocol, 5% as rewards for each pool creator, and 5% as rewards for the largest TVL contributor of each pool.

Under this incentive system, LPs will be more proactive in creating trading pairs for non-blue-chip long-tail assets. Additionally, since the largest TVL contributor can earn 5% of the entire pool's trading fees, a real competition for TVL is formed, encouraging "large and loyal" TVL to continuously provide LP, thus offering traders a better experience and better depth.

Moreover, how to solve the friction costs of futures?

The friction costs on the futures side can be transformed into non-fixed dynamic costs by introducing homogeneous trading pools with different fee rates, similar to Uniswap V3.

In simple terms, in Surf Protocol, each trade automatically establishes five different pools, each with unique fees, creating various liquidity pool structures across different assets. It is envisioned that high liquidity assets like BTC will have a significant portion of liquidity in low-fee pools, while less popular assets like PEPE may have more liquidity in high-fee pools.

For traders, these pools are transparent, and when placing an order, the system will automatically start matching from the pool with the lowest fee. Once the lowest pool is full, it will automatically move to the next fee pool. For LPs, choosing different pools is also a market game, making dynamic choices between earning higher fees and acting as a trader for closing. For the overall system, fees may significantly decrease during more stable periods (as more LPs choose low-fee pools), potentially reaching the theoretically feasible minimum level. During extreme market activities, this could translate into increased costs, preventing scenarios similar to GMX's AVAX trading pair price manipulation from continuously depleting GLP.

3. Permissionless --- The True Meaning of Crypto

Those familiar with the early history of cryptocurrency know that the early Bitcoin era emphasized the term Permissionless, rather than Decentralization. Satoshi Nakamoto used Permissionless in both the white paper and forum discussions, not Decentralization.

In other words, Decentralization is merely a form resulting from the core of Permissionless. Uniswap achieved victory in the spot DEX space through permissionless token listing and LP mechanisms.

In the derivatives space, although GMX V1 benefited from the innovation of GLP, its mechanism limited the establishment of permissionless trading pairs. The majority of derivatives trading for blue-chip and long-tail assets still concentrates on centralized exchanges, which is why we recently saw GMX V2. We need a more free and healthy on-chain derivatives financial mechanism, a fairer trading market, and an era that gradually transitions from centralized contract markets to decentralized markets.

The battle for permissionless derivatives trading has just begun. We have reason to believe that by introducing game-theoretic "homogeneous but differently priced" trading pools, along with an innovative LP reward mechanism, Surf is expected to elevate the TVL of AMM-type derivatives to a new height, providing traders with a better trading experience while better protecting LP interests, thus achieving a "win-win" situation.