Building Financial Primitives in DeFi Derivatives
As Qilin’s V2 public testnet is imminent, we’ve been more and more shifting our focus to what’s next for permissionless derivatives. Overtime, we have identified four essenetial financial primitives that are the fundamental building blocks across DeFi and different types of market. These primitives — liquidity, risk, leverage, and arbitrage — can be applied across swap, lending, and derivatives. And we can develop differentiating products in each of these markets based on a combination or a permutation of these primitives. Products that successfully combine liquidity, risk, leverage, and arbitrage in one marketplace in a easy-to-use platform would stand to address the larger portion of the market than those that simply addresses one area. As we have seen largely in the swap and lending market, these primitives are critical ingredients in making successful products:
Swap market:
● Curve’s deep liquidity in stablecoin swaps has made it the go-to marketplace for stablecoin swaps in DeFi
● Uniswap’s AMM addresses the liquidity bootstrap issue for projects
Lending market:
● Abracadabra has utilized a series of composable tokens from stablecoins to altcoins to enable users to borrow assets at leverage to increase the holding value of the assets
Yield market:
● Barnbridge has essentially created a tranched risk yield market to address the different risk preferences of yield seekers in the market
One common feature we see across these successful projects is that they have instrumentalized these primitives and are utilizing existing instruments to build a primitive.
● Curve and Uniswap have liquidity provision tokens to represent liquidity
● Abracadabra’s MIM token can be seen as a leverage token that represents the collateral provided by the borrower
● Barnbridge tokenizes risk in DeFi through their BOND token
Regardless of the instrument being the platform token itself or a debt token, the key here is that these primitives have been instrumentalized (or tokenized to be more specific). These instruments allow scalable and democratized access to these primitives.
In fact, it would otherwise be hard to perceive the advantage of decentralized protocols over centralized platforms without these token instruments. Centralized platforms safeguard their competitiveness by gatekeeping liquidity, leverage, risk, and arbitrage activities within their ecosystem. Although this helps build a “moat” for the platform, it lacks democratized access that otherwise makes it scalable in an open-source environment.
From the perspective of Qilin and the derivative market, we believe that the opportunity lies in the “instrumentalization of primitives” in the derivative market as we have yet seen such development for derivatives.
For the derivative market, we identify the following areas as key in further developing primitives in DeFi derivatives:
● Risk instrument (through debt tokens or mechanism design)
● Tokenized leverage or tokenized leveraged positions
● Liquidity market that incentivizes liquidity provision at leverage
● Arbitrage opportunities through composable standards/instruments
Out of these primitives, we have focused on the risk aspect throughout V1 and V2.
For Qilin V1, we enabled risk-based funding rate. For V2, we have improved this design and enabled per-block funding rate. By revolving around risk and realizing it through the funding rate design, we have made Qilin into the first risk-based derivative market in DeFi. Liquidity providers provide counterparty liquidity and earn risk-based fees while traders trade derivatives based on risk of the market. In addition, arbitrage opportunities exist when arbitrageurs spot risk exposure and provide instant liquidity to earn risk-based fees.
By designing such a risk-based funding rate, we have also threaded liquidity, risk, and arbitrage in one product. This gives us a nice groundwork to instrumentalize risk and the funding rate design. At the moment, our risk product exists as a mechanism that serves the purpose of better liquidity provision, but it lacks the instrument features to allow for democratized risk access in the derivative market. The logical next step would be to explore a token integration with the funding rate or risk design of Qilin Protocol.
Back in 2021, we began with the narrative that DeFi derivatives remain a highly underserved market just by virtue of its comparative and absolute low volumes. In 2022, although volumes in DeFi derivatives have grown, this narrative stands true still. But we now also understand the growth potential from the perpective of financial primitives. Based on this new narrative, we are continuing our effort in Qilin.
