December 7th 2023 | Loki, ABCDE Researcher

This article introduces Surf Protocol, aimed at providing an unlimited number of tradable assets, lower fees, and transparent settlement, enabling permissionless derivative trading for almost any assets.

2. When Decentralized Derivatives?

2.1 ProblemThe potential of decentralized derivatives has not been fully realized. According to Coinmarketcap data as of December 2023, over 2 million cryptocurrencies have been issued, with the largest exchange, Binance, offering 1,477 trading pairs for 394 tokens, while the largest decentralized exchange, Uniswap, provides at least 2,198 active trading pairs (v2+v3).

However, in the derivatives space, there is still a significant gap in asset diversity between decentralized and centralized markets. Currently, Binance offers 301 derivative trading pairs, while dYdX and GMX only offer 37 and 7 trading pairs.

Since the FTX’s crash, the market has shown a particular interest in decentralized custody of derivative trading assets.Both centralized and decentralized exchanges are exploring various decentralized solutions. But just as people associate Uniswap with decentralization and overlook permissionlessness, permissionlessness “Uniswap” is needed in the derivative market.

2.2 SolutionIn the derivatives market, especially for some niche assets, NFTs, and emerging assets, the issue is not a lack of buy/sell demand but rather a lack of sufficient liquidity providers and effective supply-demand matching mechanisms. Surf Protocol enables permissionless derivative trading by encouraging liquidity providers (LPs) to voluntarily offer liquidity and take the other side of trades for specific asset positions at a profit or loss. The contract price is determined by Oracle and TWAP price averages. Different assets have different risk structures in terms of liquidity, market capitalization, and volatility, allowing LPs to choose their fee structures. With enough LP providers, market competition will eventually lead to the optimal configuration.

3. Surf Protocol Design3.1 Trading StructureWe start by reviewing the design of Spot DEX, whether Uni V2, V3, or Curve, all operate through LPs. Providing liquidity essentially involves placing a certain number of orders in different ranges, collectively providing liquidity for traders to use. LPs are passively traded and offering the service of becoming trading counterparties at a fee. From a risk structure perspective, providing liquidity is equivalent to shorting volatility. Impermanent loss represents the realization of volatility gains and losses. In contract, LPs may not necessarily be equivalent to shorting volatility. Due to leverage, users are more likely to stop-loss and be liquidated in times of high volatility, potentially leading to additional profits for LPs.

In other words, LPs not only avoid impermanent losses but may also achieve “impermanent gains,” the opposite of the commonly referred to “the price hasn’t changed, but the position is gone.” LP’s “leveraged” behavior is beneficial to LPs, similar to how a casino operator doesn’t engage in 1:1 gambling but runs a business with guaranteed profits.

As seen, to create a trading market, it is essential to “pay a reasonable price to have an unconditional trading counterparty.” Surf Protocol is built on this premise. On Surf, liquidity providers (LPs) offer liquidity and take the opposite side of trades for specific trading pairs. This model is based on the following assumptions:

In the long run, this results in a positive expected value. Each asset’s liquidity pool is separate because each asset is considered to have unique risks that should not spread to other trading pairs. This structure isolates risks between different assets, ensuring asset independence but also expands liquidity for newly issued assets.

3.2 Effectiveness of Economic IncentivesThe essence of providing liquidity is becoming a counterparty to traders. Therefore, the key question is how to ensure the effectiveness of economic incentives. On Surf, LPs can earn at least 80% of trading fees, 100% of funding rates, 90% of liquidation residuals, and 100% of user net gains and losses. These earnings ensure that LPs have a positive mathematical expectation in the long term to compensate for the risks they take. Moreover, since operating LPs has significant benefits, LPs for new assets have the motivation to attract more users to join the trading pairs they create to maximize their profits.

In addition to this, Surf introduces two additional designs:

(1) Special incentives: Creators of each pool on Surf can receive an additional 5% of trading fees, and the largest LP in each pool can also receive 5% of trading fees. A common issue in the DeFi space is whether to have trading demand first or liquidity first. The 5% initial reward helps address the “initial bootstrapping” issue, while the 5% reward for the largest LP incentivizes liquidity and volume growth.

(2) Tiered fees: Surf currently offers five fee options: 0.05%, 0.1%, 0.3%, 1%, and 3%. Liquidity pools are used to match orders for all trader positions, executing orders in order of increasing fee levels. This design aims to accommodate a wide range of asset classes and promote effective resource allocation in the market. If the fees provided by the current LPs are too high, other LPs have an incentive to offer lower rates in profitable situations, leading to continuous competition until market equilibrium is reached. The same LP can allocate its funds across different fee levels.

3.3 Oracle and LiquidationNo derivative solution can avoid the issues of oracles and liquidation, and Surf Protocol is no exception. For mainstream assets, Surf uses a common weighted average calculation to ensure relative fairness and security of prices. For Uniswap assets, Surf innovatively proposes a comparison method using a 30-block TWMP average price and the spot price. This ensures oracle stability against common attacks and events such as flash loans and cross-blockchain attacks and prevents arbitrage risks caused by price delays introduced by the use of average prices.

In addition, Surf Protocol introduces the concept of “Leveraged LPs,” meaning that LPs can achieve greater capital efficiency, but it also amplifies corresponding risks. Viewing LPs and traders as two sides of a trade, when either side’s profits approach the other’s capital, it implies the potential for liquidation. In such cases, long and short positions will be proportionally reduced based on the ratio of LP positions liquidated to the total pool size, starting with the largest long and short positions.

4. The Future of Decentralized DerivativesIn addition to the protocol itself, we see some interesting directions:

Looking back, even after the competitive landscape of major centralized exchanges was established, many medium-sized exchanges flourished between 2018 and 2020. Afterward, permissionless decentralized exchanges like Uniswap and Curve emerged. A similar pattern may repeat itself in the derivatives space. Since 2023, NFTs, Brc-20, and Socialfi have brought us a plethora of new assets, we see a increasing demad for different assets.

In Surf, the LP tokens for each specific pool start at 1) All subsequent activities and accrued values return to the pool and are reflected in the token’s price. This includes trading fees, trader profits and losses, borrowing fees, and liquidation fees. This feature provides us with an idea — whether it’s possible to net value/tokenize both sides of a counterparty, with one simple example being “single-tokenization,” where buying a “single-token” is equivalent to investing in a fund operated by traders. 2) Another example is LP ETF, which reduces single-point risk by distributing funds across different LP pools and offers the potential for more professional liquidity management.

The market may not need another Binance or GMX, but a “Perp version of Uniswap” that accommodates as many new assets as possible is necessary. Providing liquidity for derivative trading involves varying degrees of risk for different assets, so different fee structures need to be charged to meet the need for risk compensation. The same case applies to NFTs, which may have high trading fees and royalties, and some MEME tokens with 5%-10% transaction taxes. While we cannot determine the most efficient mechanism arrangement, the market may gradually approach maximum efficiency through continuous trial and error and selection.

With the support of new assets and new paradigms, the moment of “Uniswap” for permissionless derivative trading is approaching.