On 27 September, Antonio Juliano, founder of decentralized exchange dYdX, tweeted that dYdX had reached $3.68 billion in 24-hour trading volume, surpassing Coinbase ($3.61 billion) for the first time. He left Coinbase five years ago to found dYdX, and for him, surpassing his old employer in terms of trading volume is a major milestone.
Growth opportunities for decentralized derivatives
Decentralized derivatives have become a popular track in the new DeFi market growth period. Data on the chain shows that the dYdX derivatives trading protocol topped the Coinmarketcap DEX chart in terms of trading volume on 28 September, with a daily volume of over $6.5 billion, more than all other DEXs combined.
With the increased performance of ETH and the adoption of Layer2 solutions, the trading experience for protocols such as dYdX has taken a significant leap forward from what it was before. By eliminating the need to pay Gas fees at every step of the process and by supporting instant trading, on-chain derivatives protocols have been able to build on their own transparency to achieve an experience similar to that of a centralized exchange (CEX).
Meanwhile, on-chain options protocols such as Opium, Hegic and Shield Protocol have been developing rapidly in recent times, with Shield offering an innovative trading model of ‘perpetual options’ that allows users to capture returns with reduced risk.
However, for now, there is still a large gap in the volume of on-chain derivatives protocols compared to the volume of derivatives on established centralized platforms. According to CoinMarketCap, the daily trading volume of Coin derivatives exceeds $90 billion, OKEx exceeds $20 billion and FTX exceeds $15 billion. This means that the market size of the top centralized derivatives trading platforms is still about a hundred times larger than that of their on-chain competitors.
As global regulation of crypto asset trading becomes stricter, CEX has been increasingly restricted in conducting derivatives trading business. Already this year, futures contract exchanges have ceased operations, trading platforms such as Bybit and Cryptocurrency have received regulatory warnings from multiple countries, and other platforms have chosen to reduce leverage and other methods to avoid policy risks as much as possible.
With regulation restricting CEX expansion, decentralized on-chain derivatives trading protocols have blown the whistle on the charge. As blockchains such as ETH Layer2 dramatically improve their performance and the DeFi ecosystem further develops, the potential for users to migrate to on-chain derivatives at scale is increasing, bringing the opportunity for these protocols to gradually close the gap with CEX in terms of volume.
It is foreseeable that decentralized derivatives will see an excellent round of development opportunities in the future.
At present, in the industry, the CEX and DEX derivatives are still two parallel and separate tracks, basically fighting on their own. As centralized platforms with mature products and technical reserves, most of them have failed to make a splash on DEX; while DEX, which is directly online, is often limited by various technical flaws, making the product subject to criticism and becoming a target for hackers to take care of from time to time.
Therefore, the industry is desperately calling for a centralized platform with relatively mature products to really enter the on-chain derivatives space, break the barrier between the two tracks and bring users a better product experience as much as possible.
Thankfully, the derivatives exchange BitWell has recently announced that it will enter the decentralized space with an on-chain options product, and will first choose DeFi on-chain options as its entry point.
The reason for choosing options as the entry point is that, in BitWell’s view, as a financial instrument that is widely used in traditional financial markets to hedge risk and amplify capital utilisation, it has an ‘inherent advantage’ of being on-chain in a sense, as it does not require much interaction during the position cycle.
And as a new financial industry, crypto finance certainly needs options.
Decentralized on-chain options are the inevitable trend
Compared to traditional finance, the cryptocurrency market is more volatile, which means that digital currency derivatives are more speculative and risky, and options, as a risk hedging tool, is a must-have tool in the crypto finance ecosystem.
Although crypto options still represent a relatively small percentage of the overall industry, their growth rate is undoubtedly the fastest in the segment. Data shows that in the first quarter of 2021 alone, options trading volumes have surpassed those of the whole of 2020, and as more and more traditional institutions enter the crypto space, the demand for crypto options as a risk hedging tool will grow.
We further have to ask, do options products in crypto finance have to be decentralized?
The answer is certainly yes. It is fair to say that in the long run, whether it is spot, futures or options, the transition from centralized to decentralized crypto finance is an inevitable trend in history.
Why is that?
The core reason is that decentralized products have the advantage of greater security and transparency, unlicensed and unhosted compared to centralized platforms, and it is a natural advantage of decentralization. This advantage is exemplified by the rise of Uniswap, an AMM-based spot trading model that has almost replaced centralized exchanges, fuelled by the liquidity mining and DeFi boom this year.
Futures and options trading tend to require more decentralization than spot trading, as the latter involves leveraged delivery and therefore the amount of capital and risk involved is often magnified several times compared to the former, with greater losses to investors in the event of centralized fraud.
Currently, Deribit, a centralized options platform, holds the majority of market share in the crypto-finance options market, while Opyn and Hegic have a scattered presence in the decentralized options space.
The reason for the current small market share of decentralized options is that most decentralized options platforms currently provide liquidity based on Uniswap’s AMM, while options on centralized platforms are based on a traditional order thinning model. Therefore, in the short term, the difference between the so-called decentralized and centralized options markets is essentially the difference between the thin order book model and the AMM model, which means that centralized options still hold a portion of the market share given the current state of the art.
In other words, the order book model and the AMM model will each target different user groups at some point in time, with the order book model targeting professional traders and the AMM mechanism being more suitable for retail investors.
If you are a retail options trader and only trade options occasionally, then the Uniswap AMM mechanism is well suited to this function. However, for a professional options trader, who needs to perform a complex set of operations such as large volumes of pending/withdrawing orders and strategies, only an order book mechanism can be used. At the current state of the art, the decentralized order book model is not as attractive to professional traders because of its low performance and user experience compared to a centralized exchange.
Innovation of BitWell decentralized on-chain options
BitWell has innovated this based on the fact that current ETH performance is temporarily unable to meet the order book model.
According to the official description, BitWell will use a peer-to-peer pool model to solve the liquidity problem by pooling liquidity in collateralized liquidity pools. These liquidity pools constitute a single counterparty for all options with different terms, while providing full performance collateral for the options. Risk and option fees are shared equitably by all liquidity providers on a share basis, so that no individual user is at high risk and all participants share in the benefits.
This model provides simpler and easier access to better liquidity than an order book and can have a simpler UI interface that will give users a smoother experience when placing and trading orders.
At the same time, decentralized on-chain options as components of DeFi Lego are more easily invoked by other protocols, facilitating combinations to produce richer decentralized products, which centralized protocols cannot do.
Moreover, in the future, once ETH Layer 2 scaling technology is upgraded, or decentralized exchanges can integrate well with the order book model, then centralized exchanges will naturally be replaced by decentralization. BitWell could also launch an on-chain order book model at this time, as they have entered the market with a centralized options product. At that time, BitWell’s on-chain options products will be sufficient to meet the trading needs of professional traders and provide a better trading experience for users.
In the long run, with the rise of the Layer 2 expansion solution and the improvement of the order thinning model on decentralization, decentralization will definitely replace centralized options, and this replacement will be natural.
Although decentralized on-chain options trading is still in its infancy, the explosion of the crypto derivatives track will be inevitable in accordance with the laws of financial market development. The decentralized on-chain derivatives track, precisely because it returns to the essence of the blockchain, will certainly be the main track for the future development of this field. Once the explosion is ushered in, it will be a very large market.
It can be said that a unicorn of decentralized on-chain options will definitely appear in the market in the future, just like Uniswap, or maybe even a decentralized platform of a larger scale than Uniswap. BitWell, with its mature technology accumulation in the centralized options space, will surely shine and become one of the most popular platforms in the future, after it enters into on-chain options by adding decentralization.