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Deep Liquidity, Builder-Ready, Perpetual Protocol Dex
In my search for a way to open short or long positions on certain cryptocurrencies in DeFi, I came across an exciting project called Perpetual Protocol. Below I would like to share my insights about this protocol.
Perpetual Protocol aims to provide a secure and user-friendly platform to trade financial derivatives and futures. After its launch in 2019, a reorientation to perpetual futures took place in mid-2020. The first version was launched in December 2020 on the xDai network, and version 2 in November 2021 on Optimism.
Perpetual futures are the most traded financial derivatives in the crypto world. Initially traded only on centralized platforms, they have now found their way into DeFi. With (perpetual) futures, one may gain price exposure to a certain financial product without actually holding the underlying asset and be used for price speculation, hedging, and arbitrage.
In contrast to regular future contracts, perpetual futures do not expire and can be held or traded for an indefinite amount of time.
With regular future contracts, the price of an asset’s futures, which may differ from the price of the underlying asset, converges as the settlement date approaches.
In the case of perpetual future contracts, the divergence between the two prices is counteracted by recurring funding.
Depending on whether the price of a future is trading above or below the price of the underlying asset, a positive or negative funding rate results. In the former case, open long positions fund the open short positions.
In the latter case, the opposite happens. Thus, the deviation between future and asset prices can be minimized.
On top of that, price speculation and arbitrage trading further minimize the price divergence between derivatives and the spot market. In addition to betting on falling prices, perpetual contracts also enable trading in leveraged products — with all its dangers.
Perpetual Protocol enables easy trading of perpetual contracts for the largest and most popular cryptocurrencies. The platform follows DeFi’s way that users always have control over their assets and can trade them in a transparent and permissionless manner.
While the protocol initially used USDC primarily as collateral, users can now also use other tokens as a margin. The corresponding tokens/collaterals are then paid out when a position is closed.
A major change in the iteration to version 2 of the protocol is that the execution of trades and organizing positions uses Liquidity on Uniswap V3. At the core of the protocol is the clearinghouse smart contract. This burns and mints so-called “v-tokens” for the user.
When a user deposits tokens on the platform, the clearinghouse contract generates v-tokens with the maximum possible leverage.
For example, if a user deposits 100 USDC, 1000 vUSD would be generated. If the user then wants to open a future position, v-tokens are used for this purpose.
For example, if the user wants to open a long position on ETH using USDC as a margin, the clearinghouse contract would be instructed to trade vUSD tokens for vETH token.
In this case, the protocol would rely on a Uniswap V3 vUSD-vETH LP. In this case, the user does not have to use the full leverage, i.e. only use part of his USDC previously exchanged for vUSD.
When the position is to be closed, the user can exchange his vETH tokens back against vUSD tokens. At this moment, profits or losses are fixed or secured according to the price development of ETH.
In addition to traders, market participants can also act as makers and provide perpetual futures with liquidity. Similar to regular LPs, the makers earn money from the fees of the trades.
Makers can also use leverage to provide liquidity. In detail, the provision of liquidity is a bit more complicated than with normal AMM.
For example, makers have to decide within which price range they want to provide liquidity. Thus, makers only earn money on price ranges for which they provide liquidity.
For example, if a market participant wants to provide liquidity to a vUSD-vETH pool, the user deposits USDC with clearinghouse contract, which in turn mines v-tokens and automatically generates liquidity for the corresponding token pair on a Uniswap V3 LP.
Specifically, the clearinghouse contract mines vUSD and vETH tokens in a correct ratio and automatically adds them to the vUSD-vETH LP. Similar to ordinary LP, makers are affected by impermant loss due to the price dynamics of each token in the LP.
This requires special care with the management of their strategy. The protocol is based on DeFi-typical permissionless ways, the funds of the market participants are kept in a single pool and thus all positions have this pool as collateral. This margin model, which is also called cross margin, has certain pitfalls that need to be considered when using it.
On the one hand, it simplifies the handling of the positions or the margin, since a user does not have to add or remove the margin for each individual position. On the other hand, it should be noted that individual positions influence each other.
Thus, a highly leveraged position, which develops contrary to the market participant’s expectations, can influence others own positions and even liquidate them.
However, you can also choose a different margin model. This corresponds to an isolated margin, where a user holds several wallets for individual positions.
Finally, it should be mentioned that perpetual protocol is a prime example of how projects are made possible by the use of layer 2 networks such as Optimism and Arbitrum.
Through this use, the required high data throughput and the low fees can make successful use of DeFi perpetual futures possible in the first place. It is to be assumed that just by this kind of protocol rollups will gain in importance.
The developers of the perpetual protocol also intend to enable financial derivatives not only on cryptocurrencies, but also to expand to other markets such as forex, commodity, and stock trading.
So let’s stay excited about how the whole crypto space will develop with further interesting permissionless applications like Perpetual Protocol.