1. Market background
Last updated
Last updated
1.1 Growth potential of the crypto decentralized derivatives sector
The crypto decentralized derivatives market is developing rapidly. According to TokenInsight's "Q3 2022 Decentralized Derivatives Exchange Research Report," the total trading volume of decentralized derivatives exchanges exceeded $478 billion in the past 10 months, with major contributions coming from several major crypto decentralized derivatives protocols, including dYdX, GMX, Perpetual Protocol and Drift dYdX, GMX, Perpetual Protocol and Drift. Of them, dYdX and GMX are alternative market leaders in terms of TVL, trading volume, and other data performances.
On the surface, the crypto options market has lower trading volume than crypto contract products. The $478 billion value is only the trading volume of Binance derivatives for two weeks in the current market environment. We see that at the beginning of 2021, the total trading volume of the crypto decentralized derivatives market was almost zero, but if the current trend of market development continues, the size of the decentralized derivatives market is expected to grow by more than 10 to 50 times in a year. Moreover, the crypto options market has more option protocols than before and its ecosystem is becoming more diverse.
From a different perspective, a crisis of confidence in CEX in 2022 will also facilitate CEX users to switch to DEX. Uniswap and GMX, the leading providers of crypto spot and perpetual contracts, are thus the biggest beneficiaries. While crypto spot trading may not be new to most crypto users after the 2020 DeFi Summer and meme season, crypto contracts (especially leveraged ones) are still niche. Complex clearing rules, poor interaction interface and user experience, and, most importantly, poor liquidity mechanisms hinder the development of crypto contracts.
However, two major opportunities have emerged in the past year. One is enabled by the great composability of GMX and the formation of a huge sub-ecology around GLP on Arbitrum. The other is FTX, which has greatly shaken user confidence and provides a reference point for all future CEX developments. We believe these two opportunities will help crypto contract protocols capture CEX contract users. Markets with many opportunities will undoubtedly provide us with great benefits.
Although the crypto decentralized derivatives segment has tremendous development potential, liquidity is the main problem it faces. On the one hand, the crypto decentralized derivatives protocols suffer from defective liquidity mechanisms caused by problems inherent in the crypto industry. On the other hand, the leading protocols have a lot of assets (dYdx and GMX, for example, account for the majority of liquidity), while the remaining projects are facing big difficulties.
Take dYdX for example. dYdX is a protocol most similar to CEX because it uses a central limit order book model. This also explains its popularity. This order book model, along with a large number of incentives, has allowed dYdX to be an institutional market maker and build deep liquidity for the major large assets listed on DEX. dYdX is based on Layer2 StarkEx and therefore can offer trading services without gas fees.
However, we see incentives becoming the key way for dYdX to gain liquidity. As the largest crypto perpetual contract and DEX, dYdx generated over $156.2 billion in volume (about 78% market share) and $39 million in revenue between June and December last year. However, the company lost $13.7 million during that period due to incentive transfers, resulting in a -35% margin. The company's liquidity measures are working for now, but it is questionable whether they are sustainable.
In addition, StarkEx-based applications are not compatible with each other due to the lack of compatibility in this sector. This poses a challenge for most users and liquidity providers.
In addition to dYdX, GMX (or other similar DEX protocols), a currently popular crypto-perpetual contract with leverage characteristics, also has some drawbacks related to the liquidity mechanism. The protocol uses a unique model where users can provide liquidity to a basket of index-like assets called GLP.
The GLP, which consists mainly of ETH, wBTC and stablecoins, acts as a counterparty for traders on DEX. They borrow from the liquidity pool to open leveraged positions (AMM). This means that GLP takes a "profit and loss (pnl) risk" as it generates value when traders make unprofitable trades and vice versa. GLP charges a 70% transaction fee, which is paid to ETH. With a net income of 20-30%, GLP is also one of the highest and most sustainable income channels of all DeFi.
This GLP mechanism suffers from the LP trading skew problem, i.e. in a strong, well-defined lopsided market, traders can go long or short unilaterally (GMX does not compensate for IO ). This can result in the $GLP pool of assets ($ETH or $BTC) being emptied and LPs suffering persistent losses. Thus, if LPs are in a persistent lopsided market or LPs quit due to losses, GMX enters a liquidity depletion spiral (which happened in September 2021, but there were only 100 GMX users at that time).
And if we look at the CEX market, we see that derivative products represented by contracts bring them very high profits. That is why CEXs try to bring all kinds of special derivative products to the market. This means that the profit logic of contract products is correct in itself. If the liquidity is sufficient (e.g. CEX is a centralized market making mechanism), the way the decentralized crypto derivatives contracts get proper liquidity is the key to the positive development of the segment.
While the NFT segment has gained momentum in recent years, we see that low accessibility and lack of utility have led to many problems, such as overall low liquidity, high slippage, capital inefficiencies, poor pricing and valuation. The market landscape for NFT financialization is still in its infancy and solutions are still inevitably ill performed in terms of low loan-to-value (LTV) ratios, high interest rates, lack of scalability, and illiquidity.
The performance of the NFT lending sector prior to May 2022 ( using this period is used because market conditions were more descriptive) suggests that total NFTFi lending had exceeded $40 million in 2021, while cumulative lending from January to May 2022 reached $155 million. The problem, however, is that in May 2022, NFT transaction volume was about $3 billion, while NFTfi approved $36 million in loans in the same month, representing a market penetration of NFT loans of only 1.2%.
In comparison, in a more complex credit market, particularly in the mortgage and real estate sectors, the penetration of the credit market could be over 50% of the approximately $40 trillion worth of assets. In the traditional art credit market, banks typically charge 2% to 5% for art loans, depending on the client's other assets and business, while art lenders and auction houses normally charge 6% to 9%. Art mortgages usually are valid for one year, and owners can typically borrow up to half the appraised value of the artwork.
In contrast, NFT's loan-to-value (LTV) is only between 10% and 30%, with APR as high as 50%. APR represents the annual cost of borrowing for the user and a broader measure of the user's cost of borrowing. All these parameters show that the existing NFT credit market is still highly inefficient in terms of capital utilization.
