SynFutures: The Future of Derivatives?

The following report was written by Messari Hub Analyst(s) and commissioned by SynFutures, a member of Messari Hub. For additional information, please see the disclaimers following the article

DeFi has made some incredible progress in the past years; however, it is far from complete. In order to bring the centuries-old banking system on-chain, a large amount of infrastructure has to be built out first. Although many of the core building blocks have already been adopted today, one of the most fundamental elements of traditional finance has not yet been brought on-chain at scale. It is the only financial instrument that Wall Street traders, potato farmers, and airlines are equally excited about: derivatives.

Put simply, a derivative is a contract that derives its value from the performance of an underlying. The underlying could be anything: Tesla stock, interest rates, or even coffee beans. Today, traders use derivatives to speculate on their proprietary market insights. Potato farmers and airlines, on the other hand, use the contracts to protect their bottom lines against an unfavorable change in the price of potatoes and oil. By writing a derivatives contract, the price of the underlying can be locked in and the risk can be hedged completely. This counterplay of speculators and risk managers has led to the global capital markets we know today.

The market size of derivatives has long overtaken that of the spot market. According to the Bank for International Settlements, spot transactions accounted for only 30% of the total trading volume in 2019. Futures transactions and options accounted for the larger piece of the pie of 70%. In terms of market size, futures amounted to a staggering 217% of the total spot market. To put this into perspective, derivatives were estimated to be a $560 trillion market. That is 7 times the global GDP and nearly 60 times the real estate investment market, the largest asset class following derivatives. Whichever way you slice it, there is clearly a massive demand for derivatives.

Enter Crypto Derivatives

According to CryptoCompare, the crypto derivatives market reached its peak with a total trading volume of $5.5 trillion in May 2021. Since then, volumes have stabilized around the $3.0 trillion level. Compared with traditional markets, there is still a significant amount of upside for crypto derivatives. To tap into this market, centralized exchanges (CEXes) such as Binance and OKEx began offering crypto derivatives at scale after the initial success of BitMEX. Following their lead, Coinbase, the biggest U.S. cryptocurrency exchange, filed an application with the National Futures Association for derivatives trading on September 16, 2021.

Source: The Block

The early success of CEXes - with Binance, OKEx, Bybit, FTX, and Bitget leading the charts - should not be surprising. The crypto startups could rely on proven traditional models to offer smooth on-boarding and user-friendly trading at competitive prices. Decentralized exchanges (DEXes), on the other hand, had to build out the underlying technology and find product-market fit first.

While CEXes were able to attract the masses first, there are some limitations that could prove their decentralized peers to be superior in the long run:

• Opaqueness: Investors do not have access to the behind-the-scenes mechanisms of the exchange and this could come under scrutiny in case of forced liquidations. From the financial crisis in 2008, we also learned that issuing intransparent misleading products could have disastrous consequences for investors.
• Operational inefficiency: Centralized entities face larger operational frictions and are less efficient than their decentralized competitors, who leverage automation and open-source systems.
• Regulatory risk: Binance’s recent issues with the UK Financial Conduct Authority shows that regulatory risk can affect accessibility or worse. You also never know what the consequences are if China bans crypto another dozen times.
• Insolvency risk: Investors are less prone to purchase long-term derivatives out of fear of the issuer’s insolvency. Nine out of ten startups fail, after all ...

Following this rationale, we could expect a bright future for decentralized derivatives markets. This is reflected in the growth of activity in DEXes. Trading volumes went from being barely non-existent in the first half of 2020 to over $160 billion at its peak in May 2021. Be that as it may, DEXes are still small fishes in a big crypto pond. With only 2.6% of derivatives volume compared to their centralized peers, there is still a lot of ground to be covered by DEXes. One of the projects that wants to disrupt this market is SynFutures.

SynFutures

Having released its whitepaper in November 2020, it is still early days for SynFutures. Nonetheless, the team has been busting out updates on a continuous basis and launched its Closed Alpha on June 16, 2021. The ultimate goal of the project is to become the Uniswap for crypto derivatives. And if we remember how much larger the traditional derivatives market is than the spot market, it is apparent the project could see tremendous growth if executed properly. To fund this growth, the company recently raised a $14.0 million Series A, bringing the project’s total funding to $15.4 million. Although SynFutures has not yet deployed a native token, team members have, however, confirmed the project will launch a token in the future. At the time of writing, the project counts over 40,000 total users and 4,700 weekly active users.

The go-to-market strategy of the team is to launch a decentralized futures market first, and to keep on expanding its product offering afterwards to become a one-stop-shop for derivatives. The current model allows users to easily list their own futures contracts in a permissionless way and start trading futures with just a few clicks. It is designed to be user-friendly, decentralized, and compatible with as many trading pairs as possible. Today, SynFutures is live on Ethereum, Polygon, Arbitrum, and Binance Smart Chain. Determined to build a multi-chain platform, the team plans to continue integrating new networks over time.

Source: SynFutures App

Besides the benefits we talked about earlier, bringing derivatives to the blockchain also allows for a multitude of new financial products. Following this idea, the project launched two new products: hash rate futures and non-fungible token (NFT) futures.

Decentralized hash rate futures allow you to bet on the many parameters affecting the return on mining bitcoin. The mining difficulty adjusting mechanism embedded in Bitcoin’s consensus is known to produce significant fluctuations in output and this makes it an interesting rate to securitize in the form of hash rate futures. The result: bitcoin miners can now join the potato farmer’s club and begin managing their risk more effectively. And with the global crypto mining market expected to amount to $2.6 billion by 2026, this is no trivial product.

Besides allowing users to trade on-chain parameters, the team wants to capitalize on the rapidly expanding NFT market with its new NFTures product. The platform allows users to bet on the future price of NFTs similar to traditional futures. Now instead of only being able to buy and hold NFTs, investors can use NFTures to trade long and short positions on their preferred collectible. This opens up a whole new market and enables investors to follow more sophisticated trading strategies for speculating and managing risk. Just like options and futures transformed traditional finance, SynFutures believes NFT derivatives will play an equally important role in DeFi in the future.

The first version of the protocol will consist of the three key pillars SynFutures believes are essential for the success of a derivatives market.

Permissionless Market

The advantage of decentralized derivatives projects is that they can allow for permissionless markets. What this means is that users can create trading pairs for any asset they like and trade them at their preferred maturity. This is very similar to Uniswap, except for the fact that derivatives allow for a much higher degree of configuration than spot products. Note that in the traditional OTC market, getting access to such custom products does not come without a price tag and this illustrates a large benefit of permissionless markets.

The first version of SynFutures will be a futures market and will support the trading of any ERC-20 token when it launches. Starting with price oracles Uniswap and Chainlink, additional oracles will be introduced over time with the ambitious goal of eventually enabling the trading of any asset with a price feed. This means that users will be able to take leveraged long or short positions on an underlying like Tesla stock or an on-chain parameter such as hash rates. This allows SynFutures to open up access to derivatives for the long tail of assets, such as illiquid cryptoassets, that are currently not widely available on popular platforms. Today, over 50 trading pairs are traded.

Synthetic Automated Market Maker

The success of decentralized exchanges can primarily be attributed to Uniswap’s groundbreaking Automated Market Maker (AMM) model. The protocol allows users to create trading pairs freely simply by providing liquidity in both assets. While this allowed non-Wall Street professionals to become a market maker and earn trading fees for the first time, it would be a much nicer experience for liquidity providers to only have to provide one asset. That’s because, unlike Wall Street, liquidity providers don’t have access to a team of traders to hedge the risk of their positions. With SynFutures’ Synthetic AMM (sAMM) model, liquidity only needs to be provided in one asset.

The sAMM allows for only one asset of the trading pair to be supplied and the other asset to be automatically synthesized by the smart contract. This means that if 1 ETH is currently worth 3,000 USDT, a user can supply liquidity by simply depositing 6,000 USDT to the pool. The other half of the USDT will then be used as margin to represent 1 ETH in the form of a long futures contract, giving the user exposure to a derivatives position. When the long position is created, the sAMM will enter into a short position for an equal amount. The two positions then counteract one another. The result is that there’s no added risk when the user adds liquidity to the pool. And by only having to supply one asset, liquidity providers can reduce their exposure to market risk without any hassle.

Automated Liquidator

Liquidations are another key element of trading derivatives. When a trader has insufficient balance on its account to cover potential losses, or margin in layman’s terms, the position has to be liquidated. While there are set best practices to manage liquidations in traditional markets, things become more complicated when you work with smart contracts. The ability to effectively handle liquidations, therefore, will either make or break a derivatives platform.

In other parts of DeFi, liquidators actively monitor open positions and close under collateralized ones by trading with their own funds. This is usually done through liquidation bots. The problem with this approach is that there may not be a willing counterparty to take on the risk. SynFutures created the Automated Liquidator (ALQ) smart contract to solve this issue. Instead of always relying on willing counterparties to liquidate positions, the AQL can force accounts that don’t meet margin requirements to reduce their positions. This minimizes the systemic risk to the protocol and should make it a safer alternative to current platforms. Similarly to AMMs, anyone can become an ALQ by simply providing liquidity to the protocol. This allows users to earn liquidation transaction fees without going through the complex process of actively sending transactions.

Competitive Landscape

Since its inception in 2019, the decentralized derivatives market has seen some tremendous growth. From the evolution of the monthly trading volume in the three largest derivatives protocols, you can clearly see the adoption in action. Taking off slowly as the protocols were still being built out throughout the first half of 2021, the market finally caught attention and reached its peak close to $60 billion in September 2021. At the end of September, perpetual futures platform dYdX even surpassed the 24h trading volume of Coinbase with $3.7 billion worth of trades in one day. The trading volume of MCDEX is dwarfed by the volume attracted by market leaders dYdX and Perpetual Protocol. Note that the month of October is not concluded at the time of writing and trading volume is thus on track to increase month-over-month.

Dividing up the decentralized derivatives market by product category, we find that players today typically offer just one type of product. The only exception to this rule is the derivatives exchange Synthetix. This project launched as a pure synthetic asset platform in 2018 and has since expanded its offering to options and futures contracts. Taking a step back to SynFutures, the project is following a similar strategy to its peers. The team is focussing on building a decentralized futures platform first and is planning to expand to other products from there. The question remains whether SynFutures can attract the same amount of liquidity as dYdX and Perpetual Protocol.

Main competitors

Before SynFutures can realize its ambition of becoming a Swiss army knife for decentralized derivatives, the project first needs to make a name for itself in the futures market. Currently, there are six established players besides SynFutures. dYdX and Perpetual Protocol are by far the largest players, overshadowing its competitors in terms of trading volume. Each of the players seeks to differentiate themselves with a key value proposition:

dYdX uses a centralized order book, which allows traders to submit order types used in many traditional exchanges such as limit orders and stop-loss orders, in contrast to AMMs. Perpetual Protocol, on the other hand, uses a Virtual AMM or vAMM to improve capital efficiency. “Virtual” implies that no real assets are stored in the AMM itself. Instead, collateral is stored in a separate smart contract vault, allowing traders to provide collateral for trading across all markets in a single vault. In addition, Perpetual Protocol requires no liquidity providers to supply liquidity directly to the AMM pool. As a result, there is no impermanent loss in the protocol. MCDEX utilizes a similar vAMM and wants to add value by allowing its users to create futures in a permissionless way. Futureswap uses the ever-growing Layer-2 solution Arbitrum to enable speed and composability. Injective, instead, built its own Layer-2 protocol specifically for operating its decentralized derivatives exchange. Finally, DerivaDEX introduced insurance mining to improve the security of its protocol. The project allows its users to deposit stablecoins on the app and receive DDX in return, bootstrapping capital for the insurance fund.

SynFutures is determined to provide a better solution for investors through the three key pillars we talked about earlier: (1) Permissionless market creation, (2) Synthetic market making, and (3) Forced liquidations. While SynFutures’ value proposition sounds very promising, the project has not been able to make a dent in the market yet with a cumulative trading volume of just over $150 million.

Conclusion

Everything points to significant growth prospects for the decentralized derivatives market. In traditional finance, the $560 trillion derivatives market is by far the most important asset class. Moving to decentralized finance, there is still significant upside before derivatives reach the same level of importance. And with DEXes currently only holding a single-digit share of spot volume, there is also still tons of room to grow for decentralized markets.

To seize this opportunity, we have seen a handful of ambitious projects show up. Be that as it may, only those protocols that are able to deliver a superior product to centralized alternatives and attract sufficient liquidity will have a reasonable chance of success. SynFutures believes it can make an impact on the market with its unique approach. While the project may still be in early days, it is due to launch its mainnet in Q4 this year and is planning to launch the second version of its protocol along with many new products such as perpetual futures, cross margin futures and more in the near future. Whether or not the project can realize its ambition remains unknown. Just like a derivatives contract, only time can tell what will be the outcome.

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This report was commissioned by SynFutures. All content was produced independently by the author(s) and does not necessarily reflect the opinions of Messari, Inc. or the organization that requested the report. The commissioning organization does not influence editorial decision or content. Author(s) may hold cryptocurrencies named in this report. This report is meant for informational purposes only. It is not meant to serve as investment advice. You should conduct your own research, and consult an independent financial, tax, or legal advisor before making any investment decisions. Past performance of any asset is not indicative of future results. Please see our Terms of Service for more information.

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