A deep-dive into Drift Protocol, an exciting new perpetual futures DEX making waves in DeFi.
Drift Protocol recently piqued my interest following its successful $3.8m seed round led by Multicoin Capital, which also drew funding from the likes of household names like Alameda Research, Not3Lau Capital and QCP Capital. Notable angel investors in Drift also include Jason Choi from Spartan Capital and Celia Wan of Dragonfly Capital. Its not everyday that you see such a collection of crypto and DeFi powerhouses investing in the seed round of a DeFi protocol, which was why I decided to dive deeper into what makes this project special.
Smooth. Permissionless. Transparent. Immersive.
The team over at Drift Labs observed that even with the rise of decentralised exchanges like UniSwap and Perpetual Protocol, centralised crypto exchanges like Binance and Derebit remain the dominant means of trading cryptocurrencies and their accompanying derivatives. This is unsurprising given the nascent state of the DEX ecosystem and the speed and reliability that is often attributed to CEXs.
Looking specifically at decentralised derivatives exchanges, the lack of liquidity results in poor price discovery and high slippage for users and users are often subject to high transaction costs for transferring their funds between platforms. Bottom-line: the DEX futures trading experience isn’t quite there yet.
Drift Labs’ vision is therefore to meld the best of both worlds together, bringing the speed and reliability of centralised futures trading on-chain, whilst retaining the core benefits of DEXs: permissionlessness and transparency.
Trading perps on-chain presents unique problems compared to simpler token-swap DEXs like UniSwap and SushiSwap. Perps, being derivatives of spot tokens, are more complex to price and build and hence require a more modern blockchain that offers quicker transaction speeds and reduced transaction costs.
Problems unique to Perp exchanges:
Perp DEXs require reliable and timely pricing data from oracles to ensure that users trade with minimal slippage
The processing of funding payments must be performed quickly and efficiently
Liquidations need to occur seamlessly
Solana is able to process up to 50,000 transactions per second and charges a fraction of the price for each transaction compared to the high gas fees on Ethereum, making it the no-brainer choice for developing an on-chain derivatives DEX.
Unlike token swaps which operate on an Automated Market Maker (AMM) model, where the price of tokens are determined by a constant product formula and require initial liquidity to operate, Drift Protocol utilizes a recent innovation in decentralised market making originally pioneered by Perpetual Protocol in late 2020: the Virtual Automated Market Maker (vAMM).
💡 x * y = k
where: x represents the amount of Token X y represents the amount of Token Y k represents the constant product
For those unfamiliar with the difference between an AMM and a vAMM, allow me to explain.
The basic premise of a vAMM is similar to an AMM, where prices are determined using the Constant Product Market Maker (CPMM) formula. The main difference here is that a vAMM does not require actual liquidity to start operating, hence the prefix ‘Virtual’.
The constant product k in a vAMM is predetermined by the protocol at initiation using the oracle price and is periodically adjusted along the way to maintain maximum liquidity and minimal slippage.
No liquidity providers required
Perps traded on a AMM are priced based on the assets contributed by liquidity providers into its liquidity pool, whereas a vAMM’s prices are determined by assets held in its vault sitting outside the of the vAMM. This means that Drift does not require liquidity providers to start operating and providing prices to its users
Periodic price alignment
While a traditional vAMM like Perpetual Protocol relies solely on funding payments and arbitrageurs to align pricing with the index price, Drift’s DAMM features a new re-pegging mechanism that dynamically adjusts k to recalibrate the virtual liquidity based on participant demand and open interest. This lends greater flexibility compared to traditional vAMMs and AMMs, with the aim of greater capital efficiency and reduced slippage.
Source: Perpetual Protocol Litepaper, as of 30 Oct 2021.
As with any DEX operating on an AMM or vAMM model, the biggest concern for potential users would be the slippage costs associated with the constant product formula. In instances where k is too low, users would incur high slippage when executing their trades on Drift Protocol. On the other hand, if k is too high, arbitrageurs would lack the capital required to keep prices in line with the oracle price.
As discussed above, Drift Protocol deals with this issue by manually adjusting k to ensure that prices are in line with the underlying index price. Further down the road, the team plans to eventually move towards a more algorithmically-driven approach, versus manually adjusting k each time.
Unlike traditional AMMs like Uniswap that reward liquidity providers with tokens for staking their assets, Drift’s vAMM makes it such that no liquidity providers are required. While this ensures that Drift Protocol will be ready to go from Day 1 without having to bootstrap any liquidity, it also means that Drift won’t be able to reward its users in a similar fashion.
What has the team done so far?
At the point of writing, Drift Protocol has just launched its Alpha Mainnet and has released 1,500 Drift Alpha Tickets to its community. These tickets are NFTs which are required to access the alpha mainnet and are also intended as a means of rewarding Drift’s early users for their support prior to the launch.
These tickets were distributed to Discord users, devnet beta testers and members of partner communities. Besides providing early access to Drift’s open alpha, the team also hinted that these tickets would grant their users access to future community rewards, access to trading competitions and the ability to burn them into Drift Play Pass NFTs or merch.
Given their inability to reward users in the traditional sense, I applaud the team at Drift Protocol for thinking creatively about how to keep their community engaged and developing this first means of rewarding early believers; and I look forward to seeing how the team continues to innovate on their incentives and community initiatives.
Following the success of Perpetual Protocol, FutureSwap and dYDx, the spotlight has quickly shifted from decentralised spot trading to derivatives trading. While daily trading volume on Perpetual Protocol has come off a decent bit since its May 2021 high, the number of daily active traders has only been increasing since launch, which is a good indicator of the DeFi community’s interest in decentralised futures trading.
Source: @yenwen / Dune Analytics, as of 7 November 2021.
Source: @yenwen / Dune Analytics, as of 7 November 2021.
However, as we discussed, building such a DEX on Ethereum brings a host of problems such as high transaction costs, low transaction throughput and slow finality. This makes the case for building said DEX on a more modern blockchain such as Solana. Therefore, a bet on Drift Protocol represents a bet on the growth of futures DEX trading on Solana.
Worth noting however that Drift Protocol will have to compete with the likes of more established DEXs such as Perpetual Protocol v2 (xDai) and Bonfida (Solana) and we will therefore need to watch how the team at Drift Labs are able to innovate on the existing vAMM framework to improve the trading experience for users, as well as keep their community engaged and incentivised to trade on Drift versus other exchanges.
For more information on Drift Protocol:
Disclaimer:* This content is for informational purposes only and nothing highlighted should be construed as financial advice.*