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

1. Trader Extractable Value --- The 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, as it is filled with various bots and scientists seeking potential profit opportunities in the unconfirmed transaction pool (mempool) through various arbitrage methods, which is the origin of MEV --- Maximum Extractable Value.

However, MEV tends to focus more on various arbitrage opportunities across the entire block in areas like spot Dex and lending liquidation, with more refined concepts existing in certain subfields.

For instance, regarding the reverse selection costs of Dex LP, there is LVR - Relative Loss Rebalancing, which A16Z has discussed in detail in a previous article, and we won't elaborate on that here. Additionally, there are arbitrage opportunities arising from price discrepancies between spot and derivatives, which we refer to as 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 spot price manipulation 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 liquidity, but BTC and ETH can't be played this way, right? That's partially true, but also not entirely.

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

It's not entirely true because GMX's GLP TVL is only a few hundred million. Imagine if GLP's TVL were a few billion; in a scenario where traders bet against GLP, and traders profit while LPs lose, large players would certainly spend "heavily" to manipulate BTC and ETH prices, 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 spot price manipulation costs being less than the friction costs on the futures side. As GLP's TVL increases, the possibility and success rate of TEV also 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 can we 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 its LP mechanism, creating a B2B2C trading protocol. Typically, LPs earn 70-80% of the trading fees, with 20-30% going to the protocol itself. Surf has made a crucial innovation, allocating 80% of trading fees to LPs, 10% to the protocol, 5% as rewards for each pool creator, and 5% as rewards for the largest TVL contributor in 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 holder can earn 5% of the trading fees from the entire pool, a real competition for TVL is formed, encouraging "large and loyal" TVL providers to continuously offer LP, thus providing traders with a better experience and improved depth.

Moreover, how can we address the friction costs of futures?

We can simply turn the friction costs of futures 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 a structure of liquidity pools across different assets. It is expected 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 opening a position, the system will automatically match from the lowest fee pool first, moving to the next fee pool once the lowest pool is filled. For LPs, choosing different pools is also a market game, making dynamic choices between earning higher fees and acting as a trader for closing positions. 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 like the continuous depletion of GLP due to price manipulation in GMX's Avax trading pair.

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, while GMX V1 benefited from the innovation of GLP, its mechanism limited the establishment of permissionless trading pairs, with the majority of derivatives trading for blue-chip and long-tail assets still concentrated in Cex. This is why we recently saw the emergence of GMX V2. We need a more free and healthy on-chain derivatives financial mechanism, a fairer trading market, and a gradual transition from centralized contract markets to decentralized markets.

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