Introduction

Decentralized finance (DeFi) has emerged as one of the most exciting areas of innovation in the crypto space. By utilizing smart contracts and blockchain technology, DeFi aims to recreate traditional financial services in a decentralized architecture, outside of companies and governments.

One key area of growth has been decentralized exchanges (DEX) that allow for the trading of crypto assets in a peer-to-peer manner. Perpetual contracts are one of the most popular trading instruments on centralized crypto exchanges. Now, perpetual contracts are coming to decentralized exchanges as well in the form of perpetual DEX markets.

In this blog post, we will dive deeper into this new development and understand what sets decentralized perpetual markets apart and why they are likely to drive further adoption of DeFi.

What Are DeFi Perpetual Markets?

DeFi perpetual markets are a type of financial market in the decentralized finance (DeFi) space where you can trade assets like cryptocurrencies without an expiration date. Unlike traditional futures contracts that have a set end date, perpetual markets keep running indefinitely. They use a mechanism called "funding rate" to keep the trading price close to the actual market price of the asset. This allows traders to make long-term bets on the price movement of an asset without worrying about the contract expiring.

Example: A trader uses 1 BTC as collateral to open a 10x leveraged long position in a DeFi perpetual market. Bitcoin's price rises 5%, magnifying the trader's profit to 50% due to the leverage. After accounting for a small funding fee, the trader closes the position. The net profit and initial collateral are automatically returned to the trader's wallet.

Major centralized exchanges like BitMEX and Deribit have offered crypto perpetual for some time. Decentralized perpetual markets, however, bring this same instrument on-chain by using smart contracts to enable trading in a trustless and decentralized manner. Just like their centralized counterparts, decentralized perpetual have no expiry and allow speculation on the price of crypto assets. But they cut out intermediaries and centralized entities. These markets are popular in DeFi because they offer high liquidity and flexibility, allowing traders to enter and exit positions easily.

Key Components of a DeFi Perpetual DEX

There are a few key components that make up a decentralized perpetual exchange:

• Price Oracles - To determine index prices for perpetual contracts, decentralized price feeds are used to provide market data in a manipulation-resistant manner.

• AMM Liquidity Pools - Perpetuals are traded on DEXes using automated market maker (AMM) liquidity pools rather than order books. Traders pay swap fees to LPs (liquidity providers).

• Margin Accounts - Traders must collateralize positions by depositing collateral into margin accounts. This protects against liquidations.

• Insurance Funds - System surplus fees build up insurance funds to cover liquidations that cannot be covered fully by margin collateral.

How Do DeFi Perpetual Markets Work?

There are some key differences in how trading occurs on decentralized perpetual DEXs compared to centralized platforms:

• Traders interact directly with liquidity pools rather than a central counterparty. Price slippage can occur based on liquidity.

• Margin, leveraged trading, and liquidations work similarly, but smart contracts handle the processes in a transparent and trustless manner.

• Settlement happens directly between traders rather than being facilitated by an intermediary.

Overall, decentralized perpetual aims to provide a permissionless and transparent derivatives trading experience outside of centralized entities.

Advantages of DeFi Perpetual Markets

Here are some of the benefits that perpetual DEX markets offer over centralized perpetual:

• Censorship Resistance - No single entity controls trading or can freeze funds since smart contracts power everything.

• Transparency - All transactions and liquidity pools are visible on-chain, promoting auditability.

• Composability - Perpetual protocols connect easily with the wider DeFi ecosystem of DEXs, lending markets, stablecoins, etc.

• Improved Capital Efficiency - No excess collateral is locked up at intermediaries. Margin is used efficiently.

• Fee Reduction - Lower overhead costs by eliminating centralized intermediaries and their associated fees.

Challenges and Risks

Decentralized perpetual also comes with some unique challenges:

• Liquidity risk - Liquidity pools may lack sufficient depth early on compared to large centralized exchanges.

• Oracle manipulations - Malicious actors could attack price oracles to trigger liquidations. Robust oracle designs help mitigate this.

• Smart contract risks - Code defects or exploits could lead to losses. Audits and bug bounties help reduce this risk.

• Volatile collateral - Collateral like ETH used for margin trades carries the potential for collateral becoming undercollateralized.

  
  

Why Bitcoin L2 is prime for perpetual markets and real-world examples

Bitcoin's layer 2 protocols, such as the Stacks, offer the necessary throughput for high-frequency derivatives trading while still benefiting from Bitcoin's security assurances for collateral backing.

Developers are now introducing decentralized perpetual markets to Bitcoin L2, such as on the Lightning Network-based exchange LN Markets. Users can trade perpetual for BTC and stablecoins using Lightning payments to margin trades. The combination of Lightning's low fees and speed with BTC's liquidity creates an ideal environment for active derivatives trading on L2 with decentralized settlement on Bitcoin.

Another noteworthy development is the initiative by Velar to build a perpetual DEX with Bitcoin finality. By leveraging Bitcoin's Layer 2 technologies, Velar aims to create a robust and efficient trading environment for perpetual contracts.

Future Outlook

Decentralized perpetual trading is a nascent industry, but it represents the continued expansion of sophisticated DeFi primitives that replicate the capabilities of centralized crypto exchanges in a decentralized way.

As liquidity and trading volumes grow, decentralized perpetual trading will offer traders uncensorable access to critical hedging and derivatives products without relying on intermediaries. The next major milestone will be to bridge liquidity across multiple perpetual DEXs, a step that is already underway.

In summary, perpetual DEX protocols are poised to gain significant adoption among crypto traders who seek the benefits of trustless and transparent on-chain derivatives trading.

Conclusion

Perpetual contracts have become one of the most popular instruments on centralized exchanges. The rise of decentralized perpetual markets unlocks this same instrument for DeFi traders in a permissionless manner powered by smart contracts, rather than intermediaries.

Although decentralized perpetual are still nascent, they provide a glimpse into the future of on-chain derivatives trading. As liquidity and integrations improve, perpetual DEX markets have the potential to significantly further mainstream adoption for decentralized finance.