Popular science | Liquidity mechanism of crypto derivatives

Author: Allison Lu

Translation & Proofreading: Min Min & A Jian

Source: Ethereum enthusiasts

Editor's note: Original title was "Science | Derivative Liquidity Mechanism"

In the first part of this series, we introduced synthetic assets. In this article, we will introduce different liquidity and trading mechanisms.

In the process of trading crypto derivatives, liquidity is mainly affected by three aspects:

1. Risk: What risk exposures exist? Is there a standard (for example, each BitMEX perpetual contract holds $ 100,000 worth of Bitcoin) or is it customized (for example, Song and Lubin's famous bet)?

2. Custody: Where is my collateral? How to liquidate?

3. Transaction mechanism: How can the two parties to the transaction identify each other?

Although the above three aspects are related, this article mainly introduces the different types of trading mechanisms.

Centralized order book (also known as a centralized exchange)

 

-Traders see exchanges as counterparties in a centralized order book-

The most familiar way of trading derivatives is through a futures exchange. Exchange operators define standard terms for risk and clearing. In order to effectively carry out clearing management, the operator usually keeps the pledge of the trader. They are also responsible for maintaining a centralized order book and matching both parties to the transaction. Liquidity itself produces liquidity, and network effects are difficult to replace. Exchange operators may have a monopoly.

In addition, when trading on a managed futures exchange such as BitMEX, the counterparty to the trader is actually the exchange. If the exchange disappears, or if risk management is not in place, traders will lose their synthetic assets and collateral.

-Treating an exchange as a counterparty means that if the exchange goes down, traders will follow gg-

In order to separate the various parts of the centralized order book without affecting its liquidity network effect, we can use smart contracts to separate the three areas of risk, custody and trading from each other. For example, UMA smart contracts can specify standard risk units in detail and keep the pledges of traders. However, both parties to a transaction can still identify each other through a centralized order book.

Distributed (also known as point-to-point)

 

-In peer-to-peer derivatives trading, traders directly trade-

In peer-to-peer transactions, both parties to a transaction can negotiate directly. The bet between Jimmy Song and Joe Lubin is one way to reach an agreement. However, they need to bear the risk that the other party may lie on their books. In this case, a smart contract can be used to lock the pledge to ensure that Jimmy does not overcharge. However, such peer-to-peer transactions may be relatively rare and highly customized, which makes it difficult to transfer risks and increase liquidity.

Decentralized Order Book (also known as OTC)

 

-In OTC transactions, users interact with market makers, which aggregates multiple liquidity pools-
Over-the-counter trading is probably the best way. Similar to peer-to-peer transactions, buyers and sellers interact directly, so both parties can customize terms. However, unlike point-to-point trading, in OTC trading, professional market makers aggregate long and short positions and connect multiple liquidity pools (including traditional futures and spot markets). In this way, we can take advantage of the customized advantages of the point-to-point model and improve the overall market liquidity.
-Off-market making is a golden mean-
OTC market makers are very good at risk management. Whenever a market maker engages in derivative transactions with customers, it adjusts the investment portfolio to ensure risk balance, so the risk exposure of the underlying assets is very small. Most fiat currency derivatives are traded through this OTC mechanism. Although the number of major market makers is small, the liquidity of OTC derivatives is similar to the futures of most products. Over-the-counter derivatives are also profitable: In the last quarter alone, Goldman Sachs Group made more than $ 1 billion in profits through market making — the lowest profit in nearly a decade.

If you are interested in OTC trading and how to use UMA contracts to reduce transfer risks, please contact us.

Regardless of the method used to trade these derivatives, all derivatives need to be settled through price predictors (translator's note: there needs to be a way to confirm the market price and then judge the profitability of both parties). If you can control the oracle, it doesn't matter whether your counterparty has pledged a deposit in a "decentralized" smart contract: because you can steal its assets. Some fiat currency market oligarchs use their power to manipulate the pricing of derivatives1 , 2 . We believe that we can use the power of blockchain oracles to achieve network effects without relying on existing strong forces.

In the next article, we will discuss the importance of economic assurance for blockchain oracles, and our proposed solution: UMA Data Verification Mechanism (DVM).

1 https://en.wikipedia.org/wiki/Libor_scandal

2 https://www.nytimes.com/2015/05/27/business/dealbook/sec-says-deutsche-bank-misvalued-derivatives.html

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