As we explored earlier, DEX (Decentralized Exchanges) represent a crucial pillar in the DeFi universe, providing users with a decentralized means to exchange tokens among themselves. While this practice is already established in the spot market, i.e., the exchange of tokens for immediate delivery, I observe a considerable growth of initiatives involving the derivatives market.
This is important because today in the traditional financial market, the movement of derivatives is extremely relevant and in some market sectors greater than the movement we have in the spot market. One example is Brazil itself, with the formation of its future exchange rate of the dollar traded on B3. Another example comes from the BIS's triennial report, which states that, in April 2022, only the OTC (Over-the-Counter) interest rate derivatives market recorded a daily trading volume of $5.2 trillion.
When we look for derivatives DEX in DeFi, one of the oldest and main DEX is DYDX, which has perpetual derivatives and operates on the Ethereum network.
The main difficulty in creating an exchange relates to how to attract, on one side, liquidity providers and, on the other, clients to operate there. This applies equally to both spot and derivatives DEX.
The incentives for both can be various, and in the case of liquidity providers, the most tested models in recent years always involve a capital allocation and in return a percentage of the revenue generated by the protocol. Even in the case of protocols that have their own governance token, like UNI from Uniswap, most of the revenue generated by these platforms goes to the liquidity provider and not to the governance token holder.
In the case of incentives for clients to operate on them, these come through ease of transactions, lower prices, and the possibility of process automation.
In 2021, a new model, later called 'Real Yields', began to attract the attention of those following DeFi. One of the first examples of how this Real Yields model works comes from the GMX platform. GMX is a futures DEX in the Avalanche and Arbitrum (Layer 2 of Ethereum) environment.
Initially, GMX was launched with two tokens, one for liquidity providers (GLP) and another for governance (GMX). In the case of the first token, instead of providing liquidity to a liquidity pool, as in Uniswap, you provide liquidity to an index composed of about eight assets, which is rebalanced weekly. You can provide liquidity in any of the eight assets; the difference is that the fee is higher for assets that are above the percentage stipulated by the index.
The value of GLP follows the index value (which, in turn, follows the price of the assets that compose it) plus 70% of the fees collected by the platform and the results of the gains/losses of the traders using the platform.
The other 30% of the fees go to GMX holders, being the governance token.
Let's now analyze the two tokens, starting with GMX. The buyer of this token is acquiring what I consider to be very similar to a share of this company, or rather, of this platform.
GMX has a limited supply and pays its holder a 'dividend' equivalent to 30% of its gross results. If the platform continues to progress and succeed, it won't be hard to see this token rise significantly. On the other hand, if that doesn't happen, the drop could be substantial.
As for GLP, it is an ingenious way for liquidity providers to generate collateral for the operations that the platform performs.
Unlike the trading model of Uniswap, where one agent's purchase is another's sale, here, everyone acts against the platform, so there can be more bought than sold at certain times, and GLP acts as a buffer for that.
A fee (Borrow Fee), which is proportional to the relative size of total positions, serves here as a balancing factor, attracting sellers to futures that are unbalanced towards buyers and vice versa. If there are more short positions than long ones, the shorts pay this fee to the longs; on the other hand, if there are more long positions than short ones, the longs pay the shorts.
Another crucial element in this scenario are the 'keepers', programs that constantly monitor all positions of each agent. They check if any agent needs to be liquidated for having reached the maximum loss in relation to the deposited margin. In this process, price Oracles are essential.
The GMX model for derivatives attracts many supporters and creates this movement of 'Real Yield' within DeFi. The curious thing is that if we analyze from the perspective of investment in innovation, it is a business model where the investor starts receiving dividends right at the beginning, in the case of GMX, which is not at all expected when we are investing in innovation. From this perspective, it is quite interesting, isn't it?
In 2023, GMX slightly altered this model, migrating to the inclusion of specific liquidity pools. The main reasons for this lie in the difficulty for liquidity providers to hedge GLP exposure and, consequently, have the correct PnL (Profit/Loss), and the restriction it imposed on GMX to launch derivatives of other tokens not present in GLP.
Another slightly different model is that of GNS, which is another derivatives DEX in the Polygon and Arbitrum (Layers 2 of Ethereum) environment and started with the novelty of a liquidity pool composed solely of a Stablecoin, DAI, and aims to list derivatives of almost everything.
Today, a considerable part of its movement comes from trades of fiat currency derivatives (GBP, EUR, USD, etc.) and there is beginning to be some liquidity in stock derivatives (Apple, for example).
Moreover, it has a set of Oracles that seems to be more efficient in price discovery and can greatly help with issues like Slippage, which is how much the transaction price deviated from the price predicted by the AMM algorithm.
The innovation of GNS comes from providing leverage of up to 150 times in the case of crypto derivatives and up to a thousand times in the case of currency derivatives, with a very intuitive and interesting UX.
Their model is slightly different from GMX's. Initially, GNS worked with three vaults (which we can simplify as being a 'fund', so in this case, three funds) to provide liquidity and security for the platform, in addition to launching a series of NFTs to increase the discount percentage on fees. As for the return of the platform's fees, these revert to the holder of the GNS token, which is their governance token.
During its development, GNS ended up slightly changing the model, migrating to have its token, GNS, as the one that provides collateral for the operations and discontinuing the pools that involved DAI.
It is worth remembering that the idea of this chapter – and this book as a whole – is to bring to discussion new business models and innovations and not to make investment recommendations. Both protocols described above, and several others I mention here, are in very early stages and therefore carry enormous risk.
Derivatives DEX, just like spot DEX, present interesting business models and with efficiency improvements compared to what we see in the traditional financial market, and should be intensified. Both models face challenges and the search for liquidity providers and clients to operate will be constant.
Unlike the traditional market models where regulation helps concentrate liquidity by requiring certain assets to be traded only in specific environments, in DeFi this is not present, making the focus on usability and new ways to achieve it paramount. And this is one of the challenges and beauties of DeFi. Providing solutions that fit users autonomously brings great challenges and rewards for those who succeed. What I have seen are some very interesting tests, like the ones I described above.
Now that we have analyzed DEX models that bring innovations for trading assets and derivatives, let's take a look at what exists in DeFi related to the investment fund industry.