Centralised and Decentralised derivatives are broken, Vega Protocol is solving both
Centralised exchanges and decentralised alternatives are ready for innovation — Learn how Vega aims to open the doors to a new financial system. #FreeTheMarkets
TL;DR
- Derivatives are incredibly useful instruments in financial markets yet both CeFi and DeFi exchanges come with their own unique set of challenges
- The Vega Protocol improves current DeFi and CeFi derivatives by solving for:
Cost and speed to trade, composability, frontrunning and MEV issues, providing permissionless market creation, and offering innovative liquidity incentives
Crypto futures and options currently account for ~57% of the total crypto market volume.
Despite the massive YoY growth, the crypto derivatives market remains massively underdeveloped in comparison to other areas of decentralised finance (DeFi) such as spot exchanges and borrowing/lending protocols, as well as their centralised financial (CeFi) counterparts.
As we see more institutional participation, a burgeoning decentralised infrastructure to support, and a growing decentralised derivatives market, Vega is in a unique position to solve a multitude of issues that make DeFi a better trading environment than centralised exchanges.
The Problem with Derivative Markets in CeFi and DeFi
While derivatives have an incredibly useful place in the market, they can be equally harmful. Both centralised and decentralised derivative exchanges have their unique sets of problems:
Generally, centralised finance (CeFi) derivatives suffer from: cost of trading, lack of composability, permissioned market creation, and insufficient liquidity incentives. Not to mention the lack of transparency and accountability that leaves the door open for wash trading, offering special deals for mates at the expense of other traders, and the actual trading volume is a black box.
Decentralised Finance (DeFi) derivatives similarly suffer from: cost, speed of execution, composability, some platforms require permissioned market creation, there’s an issue with front running, and liquidity incentives create a limited trading environment.
As Good as CeFi, Better than TradFi, and the Future of DeFi
The issue is that centralised derivatives exchanges have very little room for innovation because their current business models and incentives favour extractive behaviour, and they’ve consistently chosen capital-driven control over innovation and growth. This is why DeFi aims to introduce a new paradigm, and Vega is positioned to outperform CeFi in the following areas: cost of trading, permissioned market creation, and liquidity incentives.
Cost of trading is one of the silent killers of retail trading on derivatives exchanges. With fees as high as 1% per trade CeFi profits at the expense of retail traders, but Vega’s innovative fee structure is left up to market mechanics. Liquidity Providers are free to propose any fee they like, but ultimately the market decides a single fee level for all trades based on all of the LP proposals. Then individual traders have the choice to trade or not with that fee level. Find out more about Fees on Vega
Permissioned market creation is a staple of centralised finance. Exchange gatekeepers get to decide which assets are traded on which markets, limiting the number of available markets and participants–which ultimately creates less efficient markets. Vega will allow for permissionless market creation, creating a truly free and open marketplace.
Liquidity incentives in CeFi are monopolised by exchanges. Vega shifts power and rewards away from rent-seeking exchange owners toward the liquidity providers of markets. Unlike CeFi exchanges that charge both maker and taker fees for passive orders sitting on the orderbook, the Vega Protocol does not. Instead, passive orders that are taken are rewarded for the liquidity they provide, and market makers who commit to continuously provide liquidity are additionally rewarded, encouraging liquidity into a variety of markets. Takers fees are paid by traders and dispersed to validators and stakers for helping secure the network.
Improving on Today’s DeFi Derivatives
Many limitations of the decentralised derivatives market are structural due to the limitations of the chain they are deployed on–another reason why derivatives require smart contract platforms built with sophisticated trading environments in mind.
Here are a few DeFi-specific use cases that Vega solves:
Cost and speed of execution are prerequisites to an efficient derivatives market. The Ethereum network has made derivatives un-tradable without layer 2s, and the latency in trade execution makes effective price discovery extremely difficult. Vega solves this with a no gas fee structure making it cheaper to trade and with near-instant finality.
Composability is one of the most exciting features of decentralised finance, but the risks associated with cross-chain support have limited the innovation and growth of the “DeFi Legos” thesis. Vega is built for a cross-chain future with the ability to use multiple assets as collateral and settle in any crypto-asset on any supported chain (first Vega will support Ethereum ERC20 assets), paving the way for physically settled and cash-settled products, as commodity and asset tokenisation become more widespread. Centralised derivative exchanges, like Derebit or Binance, are closed-loop ecosystems that are unable to interact with other applications or ecosystems — limiting their future use cases.
Permissionless market creation is essential to truly decentralise finance. Gatekeepers in “decentralised” exchanges deciding what markets are able to be traded show little differentiation from their centralised counterparts. Vega is delivering on the promise of freedom to transact and create markets. Anyone can create markets on any underlying asset and easily attract liquidity with an innovative incentive mechanism that allows community curation of markets — a more efficient system that maximises the permissionless access, while maintaining the quality of markets created
Frontrunning and Miner Extractable Value (MEV) have been a huge obstacle for mass adoption of DeFi, especially for such a precise use case like derivatives. Miners have been preying on retail and forcing vastly more expensive transactions due to Ethereum’s MEV issues. In the future, Vega will build anti-frontrunning protection that’s built in at the consensus layer. Wendy, the pre-protocol widget, will provide cryptographic proof that a trader has had fair access to the order book–a feature not even the most sophisticated traditional exchanges can offer.
Lastly, liquidity incentives are the backbone for creating successful, self-governing markets. Unfortunately, liquidity is mostly monopolised by large funds and market makers. Solving the liquidity issue is one of the main challenges holding DeFi back from offering a superior trading experience to CeFi. Vega solves this with its unique liquidity provision mechanism and fee rebates for parties placing passive limit orders that stay on the order book. The innovative cross-margining structure further increases incentives to trade on Vega by allowing high levels of capital efficiency.
Vega Solves the Current State of the Derivatives Market
Both the centralised and decentralised derivatives landscape are ripe for purposeful innovation.
Vega Protocol is a high throughput, low latency layer 1 purpose-built blockchain for trading derivatives and margined financial products. The network is permissionless and its innovative LP structure is constructed for trading crypto-native infrastructure in order to allow anyone the freedom to trade and innovate. #FreeTheMarkets
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About Vega Protocol
Vega is Web3’s native derivatives layer. The community is creating the building blocks for a new financial system. One that puts control of the markets, the products, and the fees in the community’s hands. Vega is a decentralised network that will support the creation of derivatives markets for a variety of crypto assets. #FreeTheMarkets
