Writing

The Perpetual Protocol

January 15, 2021 | 5 minute read

There’s a long running joke that all financial innovation can be boiled down to two things: figuring out ways to take on more leverage, and (un)bundling risk to more efficiently price assets for investors.

The first major financial innovation was the separation of debt and equity back in the 1400s. This innovation unbundled risk, creating two classes of risk holders: debt (lower risk, lower returns), and equity (higher risk, higher returns).

Over the last 20 years, financial markets have become 1,000x faster, but the primary financial constructions through which the majority of capital flows are remarkably unchanged: debt, equity, preferred equity, futures, and options.

Securitization has increased the overall efficiency of large scale capital allocation, but the vast majority of the underlying assets being securitized have not meaningfully changed. The same is true for structured finance: the big banks offering these complex products are almost always hedging out the underlying exposure using the popular instruments listed above.

In terms of new financial constructions credit default swaps (CDS) and collateralized debt obligations (CDOs) have skyrocketed in popularity over the last 20 years. Both of these innovations unbundle risk, allowing investors to more efficiently price assets based on their mandates and underlying cost of capital.

The crypto DeFi ecosystem is experimenting at a blistering pace with new financial constructions. For example, there has been an Cambrian explosion of innovation in pooled liquidity market makers for a variety of instruments, including options (e.g. Hegic, Potion) and spot (Uniswap, Balancer, Curve).

However, the most important financial innovation of the last decade was popularized in 2016 by BitMEX: the perpetual swap contract, aka “perps.” There are many financial constructions that facilitate the trading of synthetic assets, but in our view, the perpetual contract is the first-order correct construction. This is clear empirically. Crypto perps trade 3-10x more than spot every day, while other synthetic constructions trade a fraction of spot. The market is clear: perps are the optimal financial construction for synthetic trading. We expect the perpetual swap contract to become wildly popular across every asset class in the coming decade.

Back in August 2020 we led a $1.8M investment in a new automated market maker (AMM) protocol focused on perpetual contracts: Perpetual Protocol, aka Perp.fi! Our friends at Alameda Research, Three Arrows Capital, CMS Holdings, Zee Prime Capital, and Binance Labs participated in the round, along with well known crypto angels Alex Pack, Andrew Kang, Tony Sheng, Calvin Liu, George Lambeth, and Regan Bozman.

Since launch one month ago, Perp.fi’s volume over the last seven days is $304M, making it as of the time of writing the 6th largest DEX on Ethereum. The project has been executing exceedingly well. Today they published a 1-month recap on progress since mainnet. In order to explain why Perp.fi is growing so quickly, it’s worth taking a closer look at its construction and the team.

The Perpetual Protocol

Perp.fi is a breakthrough financial construction. It combines the best of CeFi and DeFi: the leverage that perp traders have come to expect in CeFi, and the guaranteed liquidity and simplicity of AMMs in DeFi.

Traditional AMMs suffer from a few problems, the most notable of which are maker-side problems of impermanent loss and poor capital efficiency. Perp.fi fundamentally solves both of these problems by getting rid of makers entirely. In Perp.fi, there are only takers!

How does it work? This post from the Perp.fi team explains in more detail, but I’ll provide a summary below.

Perp.fi is powered by a virtual AMM, aka vAMM. Before trading against the vAMM, traders deposit collateral in a vault, just as they would with any other derivative exchange (USDC to start, likely other collateral later). Once collateral is deposited, traders trade perpetual contracts just as they would on centralized exchanges, but with one key difference. Rather than trading against makers who post orders on a central limit order book (CLOB), Perp.fi traders trade against the vAMM itself. The Perp.fi vAMM uses the same xy = k curve that Uniswap popularized.

Because the vAMM is virtual, k is virtual. That means it can be set algorithmically based on volumes, outstanding interest, funding rate, and other market data. As k increases, traders incur less slippage.

Like other perp venues, Perp.fi offers all the features that traders have come to expect. Perp.fi uses a funding rate to balance longs and shorts. V1 uses Chainlink as the pricing oracle to reference underlying indices. The funding rate formula is identical to FTX’s. Perp.fi offers an insurance fund to ensure that winning traders can collect their profits.

Perp.fi is powered by a token: the PERP token. The PERP token has a few functions. First, PERP holders govern the protocol, including managing parameters such as trading fees, asset listings, insurance fund management, and more. Secondly, PERP holders act as the final backstop in the event that the insurance fund is depleted. If this were to happen, the protocol mints new PERP and auctions them off to pay winning traders.

Perp.fi’s founders, Yenwen Feng and Shao-Kang Lee are serial entrepreneurs who have launched 7 companies over the last 15 years. They were early pioneers in mobile app development before the iPhone, built early real time social and mobile experiences, and more recently have been building in the crypto space for a few years. Obsessed with financial engineering and the design space of derivatives, they studied the intricacies of DeFi and realized that it’s possible to construct perpetual contracts that trade on a vAMM curve.

We have been working closely with the Perp.fi team over the last few months. They are incredibly humble and hard working, and have assembled an excellent team and set of investors and advisors around them. At every point along the way, they have been pragmatic and thoughtful, and have executed flawlessly.

Perhaps the best thing about The Perpetual Protocol is that it can be used to trade any asset with a public price feed. That means it can trade perpetual contracts for cryptos, commodities and or any asset in any asset class. By virtue of being permissionless and censorship resistant, Perp.fi will democratize access to financial markets and guarantee liquidity for billions of people around the world. We could not be more excited to help build that future.

Disclosure: Multicoin has established, maintains and enforces written policies and procedures reasonably designed to identify and effectively manage conflicts of interest related to its investment activities. Multicoin Capital abides by a “No Trade Policy” for the assets listed in this report for 3 days (“No Trade Period”) following its public release. Multicoin Capital owns $PERP tokens.

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