Decentralized Finance or DeFi is starting to come into real use.
Something that had been just Bitcoin is blooming into something that can actually
rival traditional financial institutions. Really, I mean it. These decentralized-analogs
of financial markets are something to behold. Here, I want to look at one
particularly interesting DeFi protocol by a team based out of Taiwan: Perpetual Protocol.
This profile of Perpetual Protocol is done in conjunction with 0xKowloon,
a good friend of mine. He is publishing a Substack in which he dissects DeFi protocols
at a code level. If that is something that interests you, I recommend you subscribe to it.
There will be a link in the description below. The Golden Path to Decentralized Exchanges
DeFi is a massive field. It deserves hours and hours of video. In this particular section,
I am just going to go down a golden path towards what Perpetual Protocol does.
If you already know much of this, feel free to skip ahead to the section where I discuss
Perpetual Protocol's particular contribution. That is all. I caution you from thinking
that since you watched this video, you now know everything.
Cuz you don't. You know nothing, Jon Snow. Also. Just FYI. I’ve never met these guys.
I wrote this profile using publicly available information. I did my best to be accurate but
this stuff changes fast. As the phrase goes, the best way to find the right answer on the
internet is to make an incorrect statement. And I am definitely … absolutely … 100%
for sure not telling you to buy or invest in anything. I am seriously going to be disappointed
if any of y’all bought a thing because a random voice on YouTube talked about it.
Let us begin. If you want to trade one crypto for another, let us say Ether and Bitcoin,
you need to have a counter-party to receive and complete the trade.
In the beginning, the way of doing this was to find some other guy who does the transaction
direct with you. To do it this way is called an "over the counter" transaction or OTCs.
Direct trades between two parties however are inefficient and risky.
Prices are haphazard and rife with fraud. If you have tried to buy or sell a second-hand item on
Craigslist before, you might get what I mean here. So the world developed market exchanges where
buyers and sellers can aggregate, facilitate, and regulate transactions. A stock exchange like
the New York Stock Exchange or the Taiwan Stock Exchange is an example of this. Coinbase is an
example of this in the crypto world. And AirBnb is a non-financial example relating to housing.
In a centralized market, buyers and sellers submit orders for buys and sells to an order book. The
order book's orders are often made public so that participants can best judge what offers to submit.
The market then matches up the buys and sells in an attempt to create the most efficient outcome.
Centralized market exchanges are dominant in today's world because they act as "impartial"
third parties, supposedly ameliorating the risks associated with OTC transactions. But they have
their own risks and drawbacks. This is especially the case in the crypto world, where traditional
regulation cannot help clean up market messes. For instance, maintaining custody of crypto
assets. The theft of 850,000 bitcoins from Mt. Gox, once the world's leading bitcoin exchange,
really sucked for its clients. Or rampant price manipulation
like what happened in the early 2010s. Or exit scams like a recent one in Turkey. A
crypto exchange called Thodex with 400,000 users suddenly went offline in April 2021 with the CEO
taking off with $2 billion of investors' money. One of crypto's key points is decentralization.
So what is the point of decentralizing the asset if the exchanges are all centralized?
The main question, though: How to do it? An increasingly popular alternative would be
through the use of Automated Market Makers or AMMs. Like with other aspects of DeFi,
the AMM is an algorithmic implementation of a traditional financial concept: the market maker.
Market makers exist to deal with temporary situations where "liquidity" is in short supply.
"Liquidity" meaning the ease with which an asset can be exchanged.
Market makers stand ready to provide that liquidity - constantly buying and selling stocks,
foreign exchange, or other financial assets at the publicly quoted price.
The NYSE and London Stock Exchanges have "official" market makers who help move the market
along when buyers and sellers get out of balance. Official market makers are real, actual companies
that make money from the difference in the prices of the submitted buy and sell in the order book.
The AMM seeks to achieve the same results as the traditional market maker. Traders can
submit orders to the AMM. The AMM algorithmically provides a price to those traders that executes
the trade. The liquidity comes from other DeFi users who want to earn fees from their holdings.
Similar outcome, but with a different mechanism. How it is implemented depends on the particular
DeFi startup. UniSwap, a decentralized exchange pioneer, has one approach called liquidity pools.
Perpetual Protocol offers an interesting implementation that allows it to replicate
certain trading options offered by other, more centralized crypto exchanges like Binance.
Okay, we have completed the golden path. Now we can actually start talking about
what Perpetual Protocol brings to the table. Perpetual Protocol adopted some popular aspects
of the AMM concept while rejecting others to offer their users new trading options with
fewer drawbacks. Namely, leverage options of up to 10x margin, shorting, and perpetual contracts.
A perpetual contract is a crypto-version of futures - a type of financial derivative
instrument. Pioneered by Bitmex, they allow traders to speculate
on the future price of a crypto-asset. Traditional finance traders trade gold,
wheat and oil futures to speculate on their price movements. But futures are also useful
in business. Oil producers and other commodity providers like farmers can use futures to lock
in a price ahead of time and avoid getting burned by prices suddenly changing on them
due to unavoidable conditions. Perpetual contracts are not one-to-one
the same as traditional financial futures. Most critically, they do not have expiry dates.
But the key point is that they allow for leveraged bets on an asset's future price movements.
So to sum up our progress so far: Perpetual Protocol's key differentiation
is a decentralized-exchange-offering of a crypto-version of a traditional financial
derivative asset. Ha! Got all that? The Virtual Automated Market Maker
Perpetual Protocol enables these in a decentralized way with what they call a
Virtual Automated Market Maker or vAMM. When traders want to trade on leverage,
they deposit funds (a common one would be USDC, a digital dollar stablecoin linked to the US Dollar)
into a separate vault that holds it as collateral. The vAMM credits
the trader with their requested buying power. The vAMM does not handle assets, nor is it moving
them around. Rather, it is making marks to keep track of leveraged virtual positions - virtual
ether or virtual USDC - and setting prices based on a constant price discovery function.
An interesting consequence of Perpetual Protocol doing things this way is that
it gets a lot easier to trade asset pairs right off the bat. Other decentralized exchanges like
UniSwap are making swaps against accumulated pools of the asset pair. This means that the
pool has to first reach a critical threshold size before decentralized trading can happen.
Perpetual Protocol's approach sidesteps the two-sided buyers and sellers problem that plagues
so many new marketplaces. Per the management team, launching this new feature is expected to greatly
expand the protocol’s usefulness. The Beauty of Leverage
The way Perpetual Protocol works, with its virtual tracking of assets and position values,
reminds me a little of a total return swap or TRS in traditional finance. Hedge funds
use them to gain exposure to an asset without actually needing to own it.
They pay a counter-party a set rate. And in return the counter-party makes payments based on
the return of an underlying object. The TRS owner never owns the asset, but gets cash payments like
as if they did. They start and end with cash. Likewise, on Perpetual Protocol, traders always
start and end with a stable-coin, the crypto analogue to cash. The vMM makes it such that
traders do not have to hold the underlying asset. TRS are popular in traditional finance
but it is not entirely clear if crypto traders and early adopters will be as interested in their
DeFi versions. It might take some time for traders to get their minds around the thing.
Furthermore, leverage is a beautiful, but dangerous thing. As many a Wall Street trader
might know, having excessive leverage when a position goes against you can have disastrous
consequences. It is worth noting that when Archegos blew themselves up, they were using TRS.
Likewise if your trade goes against you, Perpetual Protocol will - like any other exchange - close
your position and take your collateral. For them, if your margin position reaches a 16x
threshold then the trade gets stopped out. Team and Challenges
For Perpetual Protocol, there remain many challenges to build a decentralized exchange
with feature parity to centralized ones. For instance, flash crashes.
One large flash crash in April 2021 took the price of Ether down to $870 USD for a few moments.
Such things are probably unavoidable. Centralized markets like the New York Stock Exchange have had
decades to deal with these market failures yet they still happen. My favorite is the August 24,
2015 ETF Flash Crash, when trading of 471 different stocks and ETFs had to be halted.
Let’s talk briefly on the 10-person team. Led by serial entrepreneur Yenwen Feng and Shao-Kang Lee,
I found their documentation and marketing communications relatively straightforward
and easy to understand. They seem to get how to make developers comfortable with developing
on their platform - making themselves accessible and holding regular events.
And as 0xKowloon will point out in his piece,
the code is ambitious and sophisticated. If you want to look into how the code actually works,
check out his newsletter and post linked below in the description.
Taiwan's relatively light crypto regulation, immense savings glut,
highly educated population, and, perhaps, a brain drain from China after the PRC's crypto crackdown,
is contributing to the Taiwanese DeFi industry. Crypto meetups in Taipei are regularly packed.
And I have begun to see a plethora of blockchain and DeFi startups recruiting in Taiwanese job
fairs. There already are few emerging names of note like Steaker, CREAM Swap, high frequency
trading firm Kronos, and FuruCombo. All of which are worth checking out in a future profile.
Something that I think is interesting is that many of these startups do not seem to be focused on the
domestic market. They are looking to go outwards, based on my evaluation of their Web 3.0 design
standards and English centric documentation. The DeFi industry in both Taiwan and abroad is
in its early stages. There are 58 listed startups alone in the DeFi pulse list,
all with their own schtick. A lot of these are going to fail. But following their progress as
they develop their decentralized analogues to traditional financial markets and trading
instruments will be exciting. I like that Taiwan is in the mix of it here. And I look forward to
seeing what those teams can do in the future. Alright thanks for watching. Make sure to
check out 0xKowloon’s newsletter and I’ll see you guys later.