Announcing Derive

TLDR

Derive is a spot, perpetuals and options trading platform designed to be secure, performant and easy to use:

• Derive Protocol, a decentralized settlement protocol for spot, perpetuals and options trading.
• Derive Chain, an OP stack rollup providing high throughput, low cost settlement of transactions to Ethereum mainnet.
• Support for portfolio margin, cross-margin and multi-asset collateral.
• The Derive DAO earns trading fees from the Derive Protocol and gas fees from the Derive Chain, governed by DRV token holders.
• Trading fees accrue to an insurance fund to foster robustness of the protocol and rollup.
• A high performance off-chain matching service which matches traders and market makers and settles orders to the Derive Chain.
• A trading experience that matches the UX of centralized exchanges.
• Smart contract wallets leveraging account abstraction to improve onboarding and private key management.

V2 makes it extraordinarily easy for any developer to generate and build financial products that harness the power of derivatives:

• Automated covered call selling vault on stETH with 1.25x margin
• Capital-efficient AMMs built atop the risk engine, to 2-3x output per dollar of TVL relative to the current version
• Delta-neutral perp yield harvesting strategy vaults
• A licensed options orderbook catering to a specific region and industry
• … many many more

Note: all details mentioned in this blog are proposed, and are subject to community vote, feedback, and alteration.

Alongside this blog, you can view:

• The technical whitepaper
• A proposal to the DAO regarding the implementation of V2
• A waitlist for the proposed platform

Introduction

There’s never been a better time to be building in DeFi. We are witnessing the convergence of a number of technological, political and monetary factors to create the most favourable set of conditions that a burgeoning alternative financial system could hope for. We have:

• The proliferation of L2s and appchains that can support high performance, low cost financial products while retaining composability, self-custody and decentralization.
• A growing realization that the traditional monetary/political/financial system thrives on opacity:
  • Bank profits derived from risky bets with customer’s savings
  • Government revenues derived by taxing debt holders and salary workers by printing money and debasing their currencies.
  • Rent-seekers exploiting inefficiencies in old market structures and regulations at the expense of victims who lack the power and coordination to enact change
• An increasingly fractured global economy, leading to a need for a credibly neutral, global settlement layer.

Derive’s Mission

Options are the Swiss-Army knives of the financial world. Powerful and flexible, there is almost no case (hedging or speculative) for which a basket of options cannot be tailored to achieve the desired payoff structure. They are payoff complete in the same way that a programming language is Turing complete. It’s the dizzying variety of use-cases that make options a foundational instrument in a financial system that is programmable, interoperable, and open source.

It was this insight that formed the genesis of Derive. The aim? To build the largest generator of options in this new paradigm for finance: a volatility engine with which entrepreneurs across the world can tap into, to build powerful, automated, and customized financial products.

Taking stock

So, after two and a half years, how are we doing?

• Derive pioneered the options AMM: a new primitive that has been responsible for 60% of the on-chain options volumes amongst ETH-based DEXes since launch.
• The protocol has become a liquidity layer which has attracted 6 different teams to build products on top of.
• The protocol has been historically profitable for LPs - with the flagship ETH pools averaging 6-8% in real yield over 1.5 years and difficult market conditions. Given the complexity of quoting options across many expires and strikes, this is an incredible achievement. It also demonstrates product-market fit for the traders and integrators who use the AMM organically (and not just as an arbitrage venue for centralized exchanges).
• The protocol has generated, priced, and settled over $1.5 billion in notional volume since launch.

Room to grow

However, we’ve barely scratched the surface of what is possible. To date, the protocol’s ability to scale has been bottlenecked by capital inefficiency (the AMM chews up a lot of collateral per option sold), a monolithic architecture (making upgrades cumbersome), and the general on-chain UX (wallets, gas, bridging).

Despite this, Derive has averaged around $3 million in notional volume per day over the past 3 months. It's difficult to estimate the exact volume of DeFi options, but if we exclude protocols that merely settle on-chain (with pricing, collateralization, etc. being manually agreed off-chain), this accounts for at least half of the volume (and up to 70-80% on any given day/week).

Therefore, the on-chain option market is currently trading around $10 million in notional volume per day. According to a recent GSR report, this is only around 1% of the total options volume in crypto. Centralized exchanges currently facilitate 99% of the volume (and 98% in perps trading).

In addition to all of this, the options-specific sector of the crypto market is much smaller than spot and futures. According to the same GSR report, spot volumes are approximately 30 times larger than options, and perpetuals are a staggering 68 times larger (in traditional finance, options volumes are higher than spot).

However, this is not due to a lack of demand. The protocol has frequently turned away users and firms who want to trade ETH options in quantities of 1,000-10,000, as the current automated market maker is incapable of handling orders of such magnitude gracefully. The total notional value of global options traded in 2021 was estimated to be $1.2 quadrillion. I mention this figure not to make facile total addressable market comparisons, but to emphasize just how small DeFi derivatives really are. Derive currently generates $1 billion in notional value annually, which represents just 0.0000833333% of this market. We must acknowledge this reality, question conventional wisdom, and think from first principles when carving a path forward.

In an industry where infrastructure and picks & shovels plays dominate the headlines, there is a lack of products with a strong focus on user experience and customer acquisition. I strongly believe that DAOs like Derive have a responsibility to do the unglamorous work of finding and onboarding new users to DeFi rails. The only way we can accomplish this is by building products that can compete with their centralized counterparts based on merit alone.

A good place to start is by asking: what do options traders actually want? We spoke with dozens of professional options traders and community members to find out. Here’s what they cared about:

• A self-custodial exchange without the credit risk of a centralized counterparty that doesn’t compromise on performance
• A straightforward onboarding process that abstracts away painful onchain UX.
• A secure, transparent and user-friendly product and brand they can trust.

Without further ado…

Introducing Derive

Derive is the final form of the volatility engine. It combines the best of on-chain, with a CEX-like experience to deliver a product that will usher in a new era of volatility trading.

• Power: supporting industry-grade capital efficiency in order to offer the deepest liquidity.
• Flexibility: the protocol gracefully adapts to new use-cases and market paradigms, making for a foundational piece of infrastructure.
• Industry ready: an architecture ready to scale to all of finance.

The new version of Derive is designed to:

• Support trustless, state-of-the-art margining capabilities:
  • Portfolio margin for options
  • Cross-margin between options and perpetuals
  • Multi-asset collateral, e.g. borrow against wstETH to sell ETH covered calls
• Facilitate institutional grade order matching
  • AMMs to be redesigned and built back into the fabric of the Derive Chain
• Re-introduce options to the crypto market:
  • Beautiful, intuitive UX
  • New and advanced native strategies and structured products

Crucially, the product cuts no corners. We designed V2 to be the modular, permissionless bedrock for DeFi derivatives. For that reason, we’re committing to open sourcing the protocol, matcher and interface repositories for the community to build on. All of the critical components for trustlessness and composability reside on-chain, from initial margin requirements to liquidations. Let’s dig in…

Derive Chain

A revolutionary protocol needs a state-of-the-art foundation. We are proud to announce that Derive will be built on top of the OP Stack. A performant, battle-tested layer-2 that is pushing the boundaries of what decentralized systems are capable of. We share in the Optimism Collective’s vision of a scalable, trustless internet running on blockchain backends.

Lyra v1 was launched in August 2021 as the first ever L2 native protocol, and we will continue to push the boundaries of user experience using the latest technology. The Derive Chain unlocks:

• A high throughput, low latency and low-cost execution environment for the Derive Protocol.
• Seamless deposits and withdrawals from Ethereum mainnet and eventually other Ethereum L2s.
• The inherited security of Ethereum with a reliable escape hatch in case of sequencer downtime or misbehaviour.
• Improved user experience with smart contract wallets, gasless transactions and more.
• An EVM environment to build and deploy smart contracts.

Derive Protocol

A trustless, permissionless, scalable backend for the next generation of finance, the risk engine is the result of nearly 12 months of research and development. Margin, clearing, liquidations, and settlement for both options and perpetuals are all natively supported, trustlessly and on-chain. This architecture will allow the protocol to support the volumes that the AMM currently supports using $15m in TVL, with as little as $1m in TVL.

The protocol has been engineered with modularity as the top priority. Instead of requiring a new re-write for a different form of margin, you can simply add another lego block to the stack by spinning up a new, custom risk manager. Markets for riskier assets can be seamlessly launched without interfering with the risk profiles of more established assets (like ETH and BTC). V2 brings less migrations, faster upgrades, and more certainty for users and integrators alike. Developers can permissionlessly tap into the protocol to create custom payoff structures and margin modules, with a world of possible applications and products to choose from.

The engine is all backstopped by the new security module, which functions as a trustless, on-chain insurance fund in case of an insolvency in the risk engine. More on this later.

Matchers

Sitting atop the protocol, the Derive Matcher will facilitate order matching at an institutional scale.

At launch, the matching service will support all essential order types, as well as REST and WebSocket APIs for developers.

We designed the offchain matcher to be as modular and reusable as the onchain protocol. The matcher can run on a Mac, AWS or GCP (no vendor lock-in) and is horizontally scalable using low-latency k8s architecture. Over time, we envision many matchers run by different teams, all settling to the same protocol and chain. Matchers allows the DAO to diversify its sources of volume, building liquidity and orderflow moats that will further increase the attractiveness of the Derive Chain as a liquidity destination.

"But," I hear you say, "what will happen to the AMM?" Make no mistake, AMMs will play a key role in Derive’s future, but that alpha is better saved for another day (and an even lengthier blog post).

Derive DAO

The Derive DAO’s role in this new architecture will be to support and grease the volatility engine to foster network effects within the ecosystem, by:

• Developing a robust and well-funded security module
• Fostering liquidity on the rollup by making it an attractive liquidity destination
• Business development with the wider crypto community, DAOs, and institutions
• Developing new, efficient AMMs built atop custom risk modules
• Flexible and minimised governance

Crucially, the security module grows in proportion to the volume generated on the rollup and in the protocol. Concretely, these are from:

• Trading fees: all transactions which increase the open interest of the protocol will be charged a fee.
• Liquidation fees: users who are liquidated will be charged a small fee that scales with the risk and market value of their position.
• Interest rate spreads: A percentage of all interest paid by quote asset borrowers is taken as a fee.
• Rollup gas fees: 50% of all L2 gas fees generated on the rollup will accrue to the security module (with the remainder to infrastructure providers).

The robust governance framework that has been established over the last two years has led to a point where the treasury and protocol are fully under tokenholder control. An active, robust community will play a critical role in building a competitive moat around the V2 ecosystem.

Derive Foundation

V2 is an enormous step forward for Derive, and it deserves a steward that can accentuate the adoption and drive volume through the protocol. The foundation will be able to perform functions to assist the DAO in bootstrapping the success of V2. More concretely, it will be responsible for progressing the protocol and rollup through the remaining 4 phases of the roadmap, listed below.

Over time, the foundation’s functions are expected to be replaced by service providers who can interface with the DAO. At this point, the foundation will be decommissioned. Check out the full foundation proposal here.

Conclusion

Derive has been architected and built to last. The DAO should be vigilant in ensuring that its standards remain high, and laser focused on building products that reach users and facilitate financial flows. DeFi is a better financial system, one which is poised to begin the ascent of the exponential curve. But, the mass migration of users and financial flows that is needed to fulfil its potential will not occur by osmosis. It is incumbent on DAOs like Derive to build products and pipelines which effectuate this transition.

At the time of writing, we are about 1.5 years into a crypto bear market. ‘Where are all the users?’ is a common refrain in the industry. Despite this, people seem shocked when new models and narratives are created to evolve and even revolutionise the space. Bear markets are best for questioning longheld assumptions, building products with long term ambition, and doing things that don’t scale. We should aim high, really high, and refuse to adopt limiting beliefs just because they are the twitter consensus du jour. This means:

• Doing the difficult, manual work of business development and relationship building with institutions and individuals.
• Onboarding traditional financial flows and real world assets, doing the legal and regulatory work required to do so.
• Sparing no expense with respect to protocol engineering and user safety best practices.

If we succeed, we can lay down a cornerstone of a 10x financial system that is:

• Radically transparent
• Universally accessible
• Interoperable
• Efficient

We should expect to manually scrap and grind for the next year while we build a liquidity base. Network effects are hard to build precisely because in their earliest stages, they are often uneconomical for participants. Onboarding requires an investment of time, resources, and a leap of faith from new users. Let’s do V2 and the Derive DAO justice by embracing the challenge.

Derive is the infrastructure layer for DeFi derivatives, visit derive.xyz.