THE FUTURE OF PERPETUALS DECENTRALIZED EXCHANGES

Derivatives, especially perpetual futures contracts (perps), are undeniably the largest sector in the cryptocurrency space, representing a significant portion of the total cryptocurrency trading volume.

Almost all derivative trading occurs on centralized exchanges. Ironically, while most traders and organizations advocate for decentralized asset values, they operate on centralized servers. In recent years, decentralized exchanges (DEX) built on blockchain smart contracts have emerged. For those familiar with cryptocurrency, DEX like dYdX and GMX have garnered considerable attention and become viable alternatives to traditional centralized exchanges. However, the trading volume and user base of these decentralized alternatives remain a small fraction compared to centralized exchanges.

Perpetual futures contracts are the largest trading instrument in the cryptocurrency market. To grasp the scale, perpetual futures contracts have accounted for approximately 75% of Binance's total trading volume since 2021. Other non-US cryptocurrency exchanges have similar or higher ratios. The story differs in the US, where regulations hinder exchanges like Coinbase and Kraken from establishing a robust derivatives market. It's no surprise that Coinbase recently launched a cryptocurrency derivatives exchange overseas just a few months ago.

Source: The Block Research, Amber

However, almost all derivative trading volume occurs on centralized exchanges. To understand how centralized volume dominance compares to decentralized volume, consider that the total volume on DEX is usually 10–20% of CEX. In fact, Uniswap's monthly trading volume has exceeded Coinbase's for four consecutive months this year. In contrast, that ratio is only 1–3% for derivative trading volume.

Source: The Block, Coinalyze, Coinglass, Dune, Amber, based on 7DMA as of June 30, 2023

The main reason for this disparity between spot and perps trading lies in the greater difficulty in creating DEX for perps on par with CEX. While creating a spot DEX might be acceptable (variants of x * y = k) and relatively straightforward, doing the same for derivatives trading is much more challenging due to additional factors such as managing margin requirements, cross-margining, funding rates, leverage ratios, price oracles, insurance funds, etc.

Furthermore, since derivatives are a cash cow for centralized exchanges, competition is fierce. DEX not only have to keep up with CEX but also match the pace of innovation and improve derivatives trading like many major CEX.

To compete with CEX in the derivatives space, DEX needs various improvements such as:

Enhancing UX/UI and system security to increase stability, improving order matching engine, adding liquidation safety nets. Increasing user capital efficiency, adjusting maker/taker fees, as well as flexible adjustment of funding rates and introducing cross-margining. Leveraging MEV. Enhancing liquidity, reducing bid/ask spread.

Although all factors are essential, liquidity is the most crucial aspect of an exchange. Without it, the exchange holds no value for buyers, sellers, or market makers. Most exchanges stagnate or fail due to a lack of liquidity.

All other factors are aimed at improving liquidity on the exchange. For example, cross-margining significantly reduces capital costs for market makers, thus enhancing liquidity. A robust infrastructure allows professional market makers to manage risks when providing bids and asks. Traders also prefer exchanges with high performance and flexibility with protective measures against black swan events.

While surpassing CEX seems unlikely, we believe that perp DEX will gain a significant market share by competing in advantages that CEX cannot replicate, similar to how Uniswap and other spot DEX have garnered attention:

Composability: By bringing DEX infrastructure or parts thereof onto the chain, other DeFi projects can connect to DEX derivatives to create new features. Decentralization and transparency. Listing a diverse range of assets.

In conclusion, DEX could likely emerge victorious by applying strategies and operational models that centralized exchanges cannot mimic. Researchers at Amber Group believe that, with proper development, the perp DEX sector could reach a valuation of over $25 billion.

Compared to CEX, the current DEX market structure is still nascent and fragmented. We have every reason to maintain our confidence that the decentralized derivatives sector will continue to develop over the next few cycles.