Surf Protocol: Towards the “Uniswap moment” of the derivatives market

0xLoki

23-12-19 19:00

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Original Title: "Surf Protocol: The Uniswap Moment for the Derivatives Market"

Original Author: Loki, ABCDE Researcher

1. Overview

This article introduces Surf Protocol, which aims to provide an unlimited number of tradable assets, low fees, and transparent settlement. It enables permissionless derivative trading for almost any asset.

2. When will decentralized derivatives welcome the "Uniswap moment"?

2.1 Problem

The potential of decentralized derivatives has not been fully developed. According to Coinmarketcap data, as of December 2023, there are over 2 million cryptocurrencies issued, with the largest Binance offering 1477 trading pairs for 394 tokens, while the largest decentralized exchange Uniswap provides at least 2198 active trading pairs (v2+v3).

However, in the derivatives field, there is still a huge gap in the richness of underlying assets between decentralized markets and centralized markets. Currently, Binance offers 301 derivative trading pairs, while dYdX and GMX only offer 37 and 7 trading pairs respectively.

Since the FTX incident, the market has been particularly concerned about the decentralization of asset custody in the derivatives trading market. Both CEX and DEX are exploring various possible decentralized asset solutions. However, just as people tend to think of "Decentralization" when talking about Uniswap and overlook "Permissionless", "Permissionless" is also underestimated in the derivatives field. The "Uniswap moment" of decentralized derivatives must be permissionless.

2.2 Solution

The problem with the derivatives market, especially with some long-tail assets, NFTs, and underdeveloped emerging assets, is not that the market lacks sufficient buy/sell demand, but rather the lack of sufficient liquidity providers and effective supply-demand matching mechanisms.

Surf Protocol enables permissionless derivatives trading through voluntary liquidity provision and a risk-adjusted fee structure. In simple terms, liquidity providers (LPs) voluntarily provide liquidity and take the other side of the trade for any given asset position, bearing the profit or loss. The contract price is determined by a combination of Oracle and TWAP prices. The risk structure varies for different liquidity, market cap, and volatility currencies, so LPs can choose their own fee structure. With enough LP providers, market competition will ultimately lead to optimal allocation.

3.Surf Protocol Design Plan

3.1 Transaction Structure

First, let's review the design of Spot DEX. Whether it's Uni V2, V3, or Curve, they all achieve liquidity provision through LP. The essence of providing liquidity is to place a certain number of orders in different ranges, and the collection of these orders forms liquidity for traders to use. LP is executed passively and provides the service of becoming an unconditional counterparty for traders, charging a certain fee as compensation. From a risk structure perspective, providing liquidity is equivalent to shorting volatility, and impermanent loss is the realization of volatility gains and losses. In contract trading, LP does not necessarily equal shorting volatility. Due to the existence of leverage, users are more likely to stop loss and liquidate when volatility is high, so LP may receive additional income. In other words, LP not only does not have impermanent loss, but may even gain "impermanent profit", which is the opposite of the commonly known "price unchanged, position gone". Based on this, the "leveraging" behavior of LP is actually beneficial to LP, just like the house in a casino does not come out to gamble 1:1 with the principal, but operates this kind of risk-free and profitable business.

It can be seen that if we want to create a trading market, the most important thing is to "pay a reasonable price to get an unconditional counterparty for the transaction". Surf Protocol is designed based on this principle. On Surf, liquidity providers (LPs) provide liquidity and take the opposite position of any specific trader in the transaction. This model is based on the assumption that:

① Without considering the friction of trading, when there are enough trading behaviors, the overall profit mathematical expectation of traders tends to approach 0. It is inherently negative, and this is a consensus based on the stock market and foreign exchange market.

② Considering the impact of transaction costs (fees, wear and tear, slippage, settlement), when there are enough trading activities, the overall profit mathematical expectation of the trader is expected to be less than 0.

③The limit of the overall profit mathematical expectation of the trader is ＜ 0, which means the limit of the opponent's profit mathematical expectation is ＞ 0.

In the long run, this gives it a positive expected value. The funding pool for each asset is separate because we believe that each asset has unique risks that should not be transmitted to other trading pairs. This structure not only isolates the risks between different assets, ensuring their independence, but also provides opportunities for liquidity expansion guided by new issuances of assets.

3.2 Effectiveness of Economic Incentives

The essence of providing liquidity is to become a counterparty to traders, so the key issue is how to ensure the effectiveness of economic incentives. On Surf, LPs can receive at least 80% of trading fees, 100% of funding rates, 90% of liquidation residuals, and 100% of user net profit, ensuring that LPs have a positive mathematical expectation in the long run to compensate for the risks they undertake. At the same time, due to the huge benefits of operating LPs, every new asset's LP has the incentive to attract more users to join the trading pairs in the pool they created to maximize their benefits.

Other than that, Surf provides two additional designs:

(1) Special Incentives. The creator of each pool on Surf can receive an additional 5% transaction fee, and the largest LP in each pool can also receive a 5% transaction fee. A common problem in the DeFi field is whether there is a demand for transactions or liquidity first. The 5% startup reward can effectively solve the problem of "initial startup", while the 5% reward for the largest LP will play a greater role in the growth stage of liquidity and transaction volume.

(2) Gradient transaction fees. Surf currently offers five fee options: 0.05%, 0.1%, 0.3%, 1%, and 3%. The liquidity pool is used as the corresponding party for all traders' positions, and orders are executed in order from the lowest to the highest fee level. The purpose of this design is to be compatible with as many asset classes as possible and to promote the formation of effective resource allocation in the market. If the fee provided by the current LP is too high, other LPs will have the motivation to provide lower fees in profitable situations, constantly competing until market equilibrium is reached. The same LP can also allocate its funds at different fee levels.

3.3 Oracle and Liquidation

Any derivative solution cannot bypass the oracle and liquidation issues, which also exist in the Sur Protocol. For mainstream assets, Surf uses a common weighted average method to ensure relative fairness and safety of prices. For assets on Uniswap, Surf innovatively proposes a comparison method of 30-block TWMP average price + spot price to ensure the stability of oracles in common scenarios such as flash loans and cross-block attacks, and to prevent the arbitrage risk caused by price delay for LPs due to the introduction of average prices.