I'm a lover of a good game of chance, you can call me a gambler even. I think that offerings like this make for a unique marketing ploy to onboard people into any system or industry.
People love to test the very limits of their luck, it's addictive and can also be fun. Certainly, the extreme of it, like any other thing done to extreme lengths, is bad. That said, a moderate approach often will birth a rewarding experience.
Derivative trading is like any other game of chance, it's theoretically fair even though it can sometimes appear as the opposite.
A simple way to prove the inherent fairness of it is to consider that any attempt at manipulating a derivative will include exposure to significant risks, making said manipulation effectively “fair” because the trader or traders involved typically step into an expensive position with the potential of incurring significant losses to gain market advantage.
Derivatives come in many forms including perpetual contracts, futures, swaps and options. While all can, in some form, be built atop varying DeFi products, I'm mostly focused on perpetual contracts, as the derivative instrument for speculating on LP growths.
I think decentralized liquidity pool solutions are interesting, its enablement of autonomous trading makes it for a unique piece of tech. So why can't we speculate on the growth of the autonomous order books?
DeFi Perpetual LP Index Derivative: What It Is
Recall that I stated that they are various forms of derivatives, as such, it's crucial to understand what a DeFi LP Index Derivative is in itself first:
A DeFi LP Index Derivative is a conceptual financial instrument(meaning it doesn't exist yet) that derives its value from an index composed of multiple decentralized finance (DeFi) liquidity provider (LP) positions. It allows investors to gain diversified exposure to various LP pools across different DeFi protocols without directly managing individual LP positions.
Now, what does DeFi Perpetual LP Index Derivative mean?
A Perpetual DeFi LP Index Derivative is a type of derivative instrument that provides perpetual exposure to an index of liquidity provider (LP) positions across multiple decentralized finance (DeFi) protocols. It is a derivative contract that does not have an expiry date and is designed to track the performance of LP positions, allowing traders to take long or short positions with leverage.
This derivative settles based on the price or growth movements of the underlying LP Index, depending on the design, which may include liquidity pools from protocols like Uniswap, Curve, and Balancer.
It's important to understand that none of this exists currently, but it would be a great way to attract liquidity to DeFi and any dev may get down to making it happen in the future.
Now, certainly, most newbies could read the above and still don't really understand what it means and how any of it would be net positive for DeFi.
Well, first starters, it forces liquidity off centralized platforms and onto decentralized ecosystems, creating volume that benefits not just DeFi protocols and it's participants, but also validators or nodes maintaining the networks powering said ecosystems.
To break down how a DeFi Perpetual LP Index Derivative works, consider regular perpetual contracts.
In a Bitcoin perp for instance, a short seller “predicts” the price to fall and a long buyer predicts that it will rise. They both choose their risk tolerance levels called “leverage” which serves as a multiplier that determines how much they earn or lose as the price falls or rises.
The percentage rise or fall is multiplied against the chosen leverage amount which typically range between 2x 3x 5x 10x 20x to as large as 100x. What this means is that if the price rises or falls by 2% for instance, they will earn or lose 2% multiplied by their chosen leverage amount. If 5x, they will essentially earn or lose 2x5 which equals 10% of the value of their position.
A Bitcoin perp tracks the spot value of bitcoin, and this is something LPs don't exactly have because LPs are not exactly assets but more akin to debt instruments. So how would a perpetual contract atop of an LP work?
Well, there's a reason it's called an LP Index. The system is designed to track multiple LP positions, not just one as that would be too much risk exposure giving individual liquidity providers the greater advantage in the market.
What this means is that a DeFi Perpetual LP Index Derivative tracks the total value locked(TVL) in a specific pool by all LPs on a dex protocol like Uniswap. Liquidity in these protocols can rise and fall autonomously throughout the day as trading occurs on dexes and also if liquidity providers decide to remove liquidity.
Generally, the perpetual contract can be designed in two ways.
The first would be that it directly tracks the value of the locked assets. Meaning that its “virtual spot market” to which the perpetual derivative tracks would rise and fall irrespective of if trades actually occur in the pool.
This is high risk because what it's really tracking in the signalled values of locked assets in the pool from oracle price feeds, so the perp would indirectly be a perp of the underlying assets, essentially being influenced by secondary standard Perps and spot markets of the underlying assets in the pool.
The second implementation would be to base the perps on locked LP assets ratio. This would be the most DeFi-serving solution in my opinion.
A perpetual derivative based on token ratios in a DeFi liquidity pool tracks the relative proportion of assets rather than their market value. This means the contract reflects shifts in the composition of the pool over time, rather than price movements of individual assets.
What this means is that traders would effectively be speculating on the actual number of assets locked in a liquidity pool. They leverage their positions on the rise(growth) or fall of liquidity assets in pools.
If you really think about it, it creates a weird incentive for more liquidity to be provided to pools by short sellers as the price of assets in the pool increases because the longs on its index perp would actually get wiped out in such an event.
How?
Consider an ETH-USDC pool where ETH is the numerator asset. If you buy long, you're saying that ETH in the pool will increase. If you're shorting it, you're saying that USDC will increase and ETH will reduce.
So let's say you're buying long.
In an event where ETH Pumps, further liquidity injection by LPs would significantly increase the USDC in the pool, potentially getting you liquidated.
Weird right? Well, that's because you're betting on actual assets in the pool, not the price. A bull market works against longs because the pool pairing is “market value based” whilst the perp is entirely based on actual number of assets.
I can also see how this would help grow liquidity pools irrespective of market season. In the sense that if the virtual spot market for the Perps grows above or falls below the defined values in the liquidity pools, the funding fees charged to positions can be used to provide additional liquidity to the underlying pools or sold into it to stabilize the values instead of being paid to position holders. Effectly creating a permanent liquidity source for decentralized markets.
Certainly, this will come with a lot of risks, all round, but a careful integration could really be something huge for the ecosystem.