When we started building Vyper in January 2021, the amount of activity in on-chain apps was huge. Trading was at an all-time high, pools had lots of money and rewards for liquidity mining, and the industry standard for measuring returns — APY — was double digits. Interest rates were very low, and people were eagerly putting their money in to get a 20% “stable” yield in UST. It seemed like every type of on-chain app was going to be the next big thing and solve all the problems of the web2 user experience.
But in the world of crypto, things can change quickly. The Vyper team has been around for a while and we’ve seen the ups and downs of the market over the last 8 years. While the patterns may be similar across different market cycles, we always learn something new. Despite the dark moments of the bear market, we come out with valuable knowledge and technology that we can build on.
The last year has been particularly eventful for the industry. Many people have left the industry, but we’re still here, building and shipping products like never before. In this series, we want to share our reflections on what has been working in DeFi, what’s missing, and how we’re contributing to the industry. We’ll keep the articles short and to the point, as our expertise lies in building, not writing.
The 4 components of the trading architecture in financial markets
Let’s start at the beginning with Uniswap, which has been incredibly successful. Blockchain technology allows for non-tradable assets to become tradable in a quick and easy way, just add some tokens and UDSC to an AMM pool and bam, there is immediately a market and price discovery on the new token. Illiquid shares of promising startups are quickly replaced by tokens. Uniswap solved this issue for the spot market, where exchanges used to be king and collected hefty fees for opening new markets. The real innovation behind Uniswap was being able to list 100x more markets 100x faster than anyone else, all while creating returns for the liquidity providers for those willing to earn more on their holdings (despite some risk, known as impermanent loss).
Uniswap has met the needs of users: swapping more tokens (it has 151,000 unique pairs listed!) and earning some returns (v2 has more than 100k unique active LPs).
Uniswap enabled a mass transition from centralized exchanges to decentralized exchanges (DEXs) because it offered something not available off-chain. This is the key metric to define product market fit: users are willing to leave the comfort of a centralized platform for the barriers of a decentralized setup (eg downloading a wallet) when the product meets a true need.
It’s always been like this. When a new product solve a real need, users are willing to make the transition and ‘jump’ into the new product, there are many such cases. Sometimes, during the transition the leave something behind, but ultimately the trade-off is better.
Some people got a credit card just to buy on Amazon for their first time, people signed up on Airbnb to get a room for cheaper than a hotel, people downloaded Uber to avoid calling a cab, and people lost their privacy with Facebook to access news and pics from friends.
Taking Leverage — the case for Futures
In the early days of cryptocurrency, spot exchanges were common, but futures didn’t become popular until Bitmex launched their perpetual swap. However, it wasn’t until FTX introduced USD-margin futures in 2019 that futures really took off compared to the spot market.
While on centralised exchanges, futures volume is multiple times that of spot markets, this is not the case on decentralised exchanges where spot volume has always been greater than future volume. This is surprising, as futures have lower trading fees, less slippage, and better efficiency, so it should be more attractive to traders. One possible reason for this is that there are not many perpetuals available to trade with low liquidity outside of the top 10 coins on decentralised platforms. For example, dYdX offers around 35 markets while GMX offers less than 10. In comparison, Binance has over 200 different perpetual markets and FTX had over 500 before they closed.
In crypto, attention span is huge, and many people want to constantly rotate and trade the hot new launch. Imagine a world where dYdX was the first platform to list a perpetual on the day of token drop like $BLUR.
The difference between centralized exchanges (Cex) and decentralized exchanges (Dex) when it comes to derivative instruments is quite significant.
Cex’s Deribit and Paradigm dominate the market with high volumes and new ATH in terms of notional traded, indicating clear institutional interest and demand. This is evident in the large size of trades and assets traded. Additionally, institutional traders often need exposure without holding the spot asset, which can be difficult due to regulations and security measures.
However, no DeFi options venue has gained significant and long-lasting usage, which may be due to the complexity of options and the non-linearity of the payoff, making it a big obstacle for retail traders who are new to this type of instrument. Retail traders wants more leverage, which — as of today — is easier to achieve with perpetuals.
On the supply side, on-chain order books are expensive to maintain and update, which makes it costly in terms of gas fees and time spent compared to the actual demand for the product. Options automated market makers (AMMs) are also hard to scale in terms of pricing efficiency. In short, the off-chain and on-chain user base for options is very different, requiring specific product fine-tuning for each one.
Decentralised Options vaults (DOV) are a great example of a first in kind product that has emerged in popularity almost only on chain. With its simple and user-friendly interface, it attracted a lot of retail users who wanted to earn extra yield while holding their favorite assets during the all-time highs.
However, despite the initial hype, DOVs failed to deliver good returns and experienced a drop in users and Total Value Locked (TVL) since their launch. The reasons for this include the financial inviability of the current strategies for all market conditions, underestimation of risks (users can lose all their initial capital with a covered call), and overestimation of returns (annualizing weekly returns). Additionally, there are misaligned incentives between buyers and sellers, which leads to big gaps and mispricing between on-chain and off-chain option pricing.
Nevertheless, the strong demand for this type of products showed that this is one of the most promising areas for user acquisition, despite the fact that a lot of operational things have to change around those types of products.
In the upcoming article, we’ll take a look at the remaining obstacles for each of the instruments mentioned earlier that need to be overcome to achieve widespread adoption.