Bye Bye DeFi & Hello World
Over the past two years, I've dedicated myself to creating a DeFi derivative known as Poption. Despite my dedication and effort, I've reached a decision to step away from this project. My belief in DeFi as a viable solution for the challenges I sought to address has waned. However, I find it important to share the insights and lessons learned from this endeavor. With this sharing, I aim to close this chapter of my journey and open the door to new adventures and opportunities.
Identifying Financial Market Challenges
The financial landscape two years ago was punctuated by several significant events: the GME short squeeze, WTI's dive into negative pricing, and the London Nickel squeeze. These events inspired me to explore strategies to prevent such market anomalies. I came up with several approaches that could offer solutions:
- Contractual Precision: It is crucial to have precise and unambiguous contracts from the start. Mid-course alterations, like changing a non-negative number to an arbitrary one, can lead to chaos. Thus, any contract modifications must be handled with utmost care.
- Hedging on Native Markets: Relying on distant markets with only similar products for hedging introduces substantial and unforeseen risks.
- Rethinking the Atom unit in Option Trading: The market should aim to reduce unnecessary naked short selling. Echoing Elon Musk's views, it is unfair for large entities to sell what they don't own. A viable alternative could be for market makers to trade in bundled option strategies such as call/put spreads or butterflies, which can help in managing high-risk positions more responsibly, as seen in the GME scenario.
The Journey
When I first embarked on my journey into the world of blockchain, I was filled with optimism, seeing it as the solution. The prospect of starting anew in this innovative space was incredibly enticing. The trustless nature of blockchain and the precision of smart contracts appeared to be perfectly aligned for establishing contractual precision and fostering native markets. This led me to conceptualize a decentralized exchange (DEX) on the blockchain for trading 'Poption', an innovative derivative designed to leverage the benefits of traditional options without the associated risks of naked selling.
However, I quickly encountered significant challenges. A major obstacle was the lack of a well-established derivatives market within the blockchain sector. Traditional assets, despite being supported by existing derivatives markets, struggled to find their place in this new digital environment. For example, tokenized gold, despite its availability, experienced minimal trading volume. Moreover, the high perceived risk associated with cryptocurrencies deterred their use in risk management and derivative trading.
I came to realize that blockchain primarily serves as a market for new issues rather than being suitable for a secondary market. Even with cryptocurrencies, the main secondary market is found within centralized exchanges. The cryptocurrency realm largely functions as an area of regulatory arbitrage, limiting the scope for derivatives, which flourish in a mature secondary market. Notably, centralized exchanges continue to dominate the secondary market in the crypto sector.
Understanding why this occurs was straightforward (though it took me a long time to discern). DeFi is inefficient. The cost of gas and the activities of MEV bots make transactions expensive and highly unfriendly for high-frequency traders. Furthermore, once a centralized exchange earns the market's trust and becomes regulated by the traditional system, it may offer greater security than using DeFi solutions (e.g., no hacks/account recoverability...).
Will the situation change? Unlikely. Miners enjoy the high fees and special rights the system grants them and have little incentive to change. Moreover, the system does not prioritize transparency, as it profits from criminal activities. Therefore, it appears unlikely to change, signaling that it is time to move on.
Ideas Still Useful
Though the project didn't reach its intended objectives, the journey wasn't without its merits. Here are some enduring ideas from our endeavors that could serve as inspiration or possibly be re-explored in the future.
Code as Contract
The growing trend of encoding protocols directly into software is reducing the ambiguity of traditional text-based contracts, offering a clearer and more accurate way to establish agreements. Despite the advantages, the risk of bugs presents a significant challenge. Nonetheless, the "code as contract" concept is poised to become increasingly important, especially as we enter the AI era, indicating its crucial role in future developments.
Hedging in Native Markets
Blockchain technology offers potential solutions for hedging in native markets, primarily by enhancing transparency and security. This approach could involve the off-chain management of storage and the tokenization of products, complemented by on-chain trading and derivatives activities for added complexity. Despite current challenges, such as technological limitations, regulatory uncertainty, and a lack of trust, blockchain has the potential to become a valuable addition to the traditional financial ecosystem. It can offer specialized options that existing systems might not provide.
Safer Option Trading Strategies
To enhance safety in the options market, we could minimize trades that carry high risk during rare market events. Typically, selling a call option and a bull spread call (with a high high strick price) (a safer trade with limited loss potential) perform similarly under normal conditions. However, their outcomes diverge significantly during market anomalies, such as sharp price increases. A naked call, where the seller doesn't hold the underlying asset, carries greater risk compared to a bull spread call. By altering the standard practices of traders, particularly market makers, we can foster a more secure trading environment. Shifting the basic trading unit from simple calls or puts to structured strategies like spread calls/puts or butterflies could reduce overall market risk, benefiting nearly all participants by making trading inherently safer.
Embarking on a New Chapter
In conclusion, my confidence in DeFi as a provider of viable solutions for derivatives has diminished. Consequently, I am saying goodbye, prepared to venture into the next chapter. It's time for me to seek out new horizons and continue my journey. The world is vast, offering endless perspectives waiting to be discovered. Let's set out.