Derivatives: dYdX picks low hanging fruit

dYdX is an exciting project that allows for derivative contracts to be built for any pair of underlying ERC20 tokens.
 | Job Berckheyde, The old exchange, Amsterdam, circa 1670| Amsterdam was the home of the world’s first stock exchange in 1602 by the issuance of shares in the Dutch East India Company (VOC). Equity derivatives followed: forward contracts on VOC shares were being traded by 1607. In crypto the first decentralised exchange was BitShares, and now dYdX will be the first decentralised protocol for derivative trading

| Job Berckheyde, The old exchange, Amsterdam, circa 1670| Amsterdam was the home of the world’s first stock exchange in 1602 by the issuance of shares in the Dutch East India Company (VOC). Equity derivatives followed: forward contracts on VOC shares were being traded by 1607. In crypto the first decentralised exchange was BitShares, and now dYdX will be the first decentralised protocol for derivative trading

The inventor of smart contracts Nick Szabo once wrote: ‘In a few years teenagers in Indiana will be swapping over-the-blockchain derivatives with grandmas in India without asking New York City’. dYdX is an exciting project that is about to make this a reality. We spoke with Zhouxun Yin, head of operations at dYdX this morning. What the 0x project is doing for decentralised exchanges, dYdX is doing for leveraged trading, and potentially for other types of options.

There are derivatives based on virtually all traditional assets. Commodities, currencies, even weather, are traded as futures. On the options side, stock and indices are common examples. Derivatives are a great way to manage risk in a portfolio, improve market efficiency, and significantly improve price discovery. Yet the approximately $1.2 quadrillion global derivative market has thus far had a limited impact on crypto. This is a big deal: the current toolbox available for crypto investors who want to create strategies that hedge portfolio risk are unsophisticated and full of friction. This is somewhat paradoxical because the problems that are causing these inefficiencies can be directly solved by tokenisation and smart contracts. Derivatives attract broker and intermediary fees, are centralised around a few major exchanges, and are agreements that are built on systems with clear rules and quantifiable terms of agreement. For these reasons, Apollo Capital has long thought of derivatives as low hanging fruit for smart contract technology that trustlessly can be executed as written.

Currently, if you want to execute a derivative trade in crypto, there are ways, but most are offered through centralised offerings, or limited to Bitcoin. Many exchanges, such as Poloniex, also offer futures margin trading. BitMEX is a peer-to-peer trading platform that offers leveraged contracts that are bought and sold in Bitcoin. Until now we’ve been a way off from being able to use derivatives across large segments of the crypto asset class on a decentralised trading platform. There have already been some attempts, like Velocity, but that project takes an oracle based approach which makes it difficult to compete with centralised solutions from an efficiency perspective.

dYdX is building a decentralised protocol for derivatives, built on the Ethereum blockchain and the 0x protocol. The protocol is creating a liquidity pool for leveraged positions on any ERC20 token. Interestingly what they might be able to create are tokens based on these smart contracts, i.e. short and leveraged long ERC20 tokens based on any ERC20 token as an underlying instrument.

How would this look? Currently, dYdX is only looking at tokenising short and leveraged long positions. A ‘short token’ would negatively correlate with the underlying crypto asset. The price of the short token would thus increase when the price of the underlying asset decreases. Conversely, a ‘leveraged long token’ would move at a multiple of the price of the underlying crypto asset. The leveraged long token increases by >1 when the underlying asset increases in value. And because these derivative positions are tokens, they can be integrated into any centralised or decentralised exchange that supports the standard, be stored in any ERC20 compliant wallet, provide frictionless buying and increased liquidity. And while you’ll only be able to trade with ERC20 tokens (and Ethereum itself, wrapped), with time, cross-chain atomic swaps will enable trading of non-ERC20 tokens.

dYdX’s order books will be off chain with on-chain settlements, which allow for faster trading, especially during times of network congestion. But more exciting, dYdX will look to tokenise these contracts, basically re-creating what we in traditional markets have — in short, leveraged ETFs that are fully decentralised and freely tradable — that’s an incredibly powerful concept.

dYdX was founded by Antonio Juliano, a former software engineer at Coinbase and Uber and they have raised a seed round led by Andreessen Horowitz, Polychain Capital, Fred Ehrsam, Brian Armstrong, Elad Gil and others.

We’ll be watching this project closely. 

[Disclosure: Apollo Capital has not invested in dYdX]