An article to understand the use of vAMM's Perpetual protocol DeFi derivatives will be the next tipping point

In the DeFi space, an automated market maker (AMM) is used to describe a protocol or application that utilizes mathematical functions to determine the price of an asset and facilitate the exchange of two or more assets. The most famous example of AMM is Uniswap, as a decentralized exchange (DEX), it utilizes a constant product function (x*y=k) for token swaps.

Since the introduction of on-chain AMMs by Bancor in 2017, AMMs have seen some notable improvements in different aspects.

1. Uniswap (2018): The first AMM to achieve meaningful transaction volume and set off a wave of AMMs in the DeFi field. The success of Uniswap is largely due to its simplicity.

2.Curve (2019): The first AMM optimized for stable asset baskets;

3. Balancer (2020): The first AMM that enables creators of liquidity pools to customize weights between two or more assets in a single pool;

4. Bancor V2 (2020): The first AMM to introduce the dynamic weight of the liquidity pool to alleviate the impermanent loss of the liquidity provider (LP). In addition, Bancor also allows LP to provide an asset to the asset pool to participate in market making;

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5. Blackholeswap (2020): The first AMM to use the supply of Compound or other lending agreements to process excess liquidity pool transactions;

On the basis of this innovative chain, it is an honor to share with you a new type of AMM created by the Perpetual protocol: Virtual Automated Market Maker (hereinafter referred to as "vAMM" or "vAMMs").

While there has been a lot of innovation in the AMM space, all of the aforementioned improvements have been focused on token swap services, which means that each new approach is only applicable to swaps and not to derivatives (such as perpetual contracts).

We know that perpetual contracts are the favorite product of cryptocurrency traders. Since derivatives typically involve some kind of leverage, it is difficult to make them compatible with current AMM designs. However, there are indeed some possible approaches. For example, one way to leverage and short-sell with AMMs is to encourage liquidity providers to offer tokens in AMM pools (=1x leverage) and allow traders to borrow assets with the leverage they want. You can learn more about this method here. However, the disadvantages of this approach are:

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(1) Liquidity Providers (LP) will suffer high impermanent losses

(2) The open interest rate is constrained by the size of the asset pool.

3

Perpetual protocol solution: virtualized AMM

In order to solve the limitations of the current AMM scheme, the Perpetual protocol introduces a new method called "virtual AMM", which fundamentally expands the application space of AMM and realizes perpetual contracts for the first time.

For those unfamiliar with perpetual contracts: A perpetual contract is a derivative product similar to a futures contract, but it has no expiration date. For conventional futures contracts such as WTI, as the expiration date approaches, the price of the contract will gradually converge with the spot market price of the underlying asset. As for the perpetual contract, to make its price consistent with the spot market price, the most effective method used in the industry is the "funding rate". You can read our documentation, or this article on the FTX Help Center to learn more about how funding works.

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The vAMM of the Perpetual protocol uses the same x*y=k constant product formula as Uniswap. As the vAMM "virtual" part implies, the vAMM itself does not store the real pool of assets (k). Instead, the real assets are stored in a smart contract vault that manages all collateral backing vAMMs. Unlike traditional AMMs, Perpetual Protocol uses vAMMs as a price discovery mechanism rather than for spot trading.

Here is an explanation of how vAMM works:

1. Before creating a vAMM on the blockchain, the creator sets the amount of virtual assets stored in the vAMM. Assuming that the transaction price of Ethereum is 400 DAI, the creator can set the initial amount of ETH and DAI on vAMM, with a ratio of 1:400. For simplicity, let's assume that the creator sets the initial state of vAMM to 100 vETH and 40000 vDAI.

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2. Trader Alice wants to use 100 DAI as collateral, and then do 10 times more ETH:

(1) Alice deposits 100 DAI into the vault of the Perpetual protocol. As mentioned above, this is a smart contract on the Perpetual protocol.

(2) The Perpetual protocol credits 1,000 vDAI (10 times the leverage of 100 DAI) from Alice into vAMM, and vAMM calculates the amount of vETH received by Alice according to a constant product function (x*y=k).

(3) The Perpetual protocol records that Alice now has 2.4390244 vETH, and the state in this vAMM becomes 97.5609756 vETH and 41000 vDAI.

3. Trader Bob then uses 100 DAI as collateral to short ETH 10 times, which means:

(1) Bob deposits 100 DAI into the same vault.

(2) The Perpetual protocol credits -1,000 vDAI from Bob to vAMM, and vAMM calculates the amount of negative vETH received by Bob according to a constant product function (x*y=k).

(3) The Perpetual protocol records that Bob is now shorting 2.4390244 vETH, and the internal state of this vAMM has now become 100 vETH and 40000 vDAI.

1. No liquidity provider required

Due to path independence, the vault will always have enough collateral to repay all traders against the vAMM (assuming all undercollateralized assets are successfully liquidated before bankruptcy). The liquidity of traditional AMMs comes from the assets provided by liquidity providers (LPs) to facilitate transactions. Unlike the liquidity of vAMMs, the liquidity of vAMMs comes directly from vaults outside of vAMMs. In other words, there is no need for liquidity providers to bring liquidity to vAMMs, traders themselves can provide liquidity to each other.

Since there is no need for liquidity providers in vAMM, there is no impermanent loss problem from the beginning.

2. Periodic price adjustment

vAMM itself is an independent cash settlement market. If we want the vAMM market price to be close to some underlying index, we need to add a financing rate, similar to the financing payment for perpetual contracts on central limit order book (CLOB) exchanges. For example, the following is FTX's financing payment formula:

This financing payment incentivizes arbitrageurs to keep the market price as close as possible to the underlying index and make the vAMM market track the underlying index.

The Perpetual protocol utilizes a funding rate formula similar to FTX, thus allowing new derivatives markets to trade with leverage while closely tracking the underlying index.

Manage slippage

Similar to traditional AMMs, traders experience less slippage when vAMMs have higher K values, but the similarities end there.

For traditional AMMs, the methods to increase the K value are

(1) Encourage more liquidity providers to provide more liquidity

(2) Increase transaction fees and recover transaction profits to provide more liquidity.

In contrast, in vAMM, since the K value is manually set by the vAMM operator at startup, K can be increased or decreased at will at any time even after the vAMM is created, which helps the market react to the latest situation. response. Having said that, although a vAMM operator has this power, he/she cannot transfer user funds stored in the vault. The vAMM operator will be the Perpetual protocol team in the first version and transition to a DAO structure later.

While the first version of the Perpetual protocol will set the K value manually, over time we expect the K value to be set algorithmically. For example, K can be set as a function of volume, open interest, financing payments, volatility, and other variables.

The setting of K value needs to maintain a delicate balance. If the K value is too low, natural users of the protocol will generate excessively high slippage and inhibit their transactions in the system. However, if the K value is too high, then arbitrageurs will not have enough funds to maintain the vAMM price in line with the underlying index price.

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