TracerDAO & Perpetual Pools
Decentralized Derivatives on the Blockchain
Derivatives are financial contracts based on underlying assets. This is one of those words that often confuses a lot of people, so let’s use a quick practical example to clarify what it means:
Let’s say (hypothetically), crypto X is trading at $100. I am optimistic on the future of crypto X and believe that it should actually be trading at $110 based on my analysis. Obviously, I want to make money from this trade. So, I can go and buy some crypto X with $100 and sell it at $110. My returns are 10% - great.
But, let’s imagine I want to make even better returns. My friend Joe is bearish on crypto X and believes that it’s “hot-garbage”. Being the financially savvy individual that I am, I recognize that this is a fantastic opportunity for me to make some money. So, I go to Joe and we each wager $100 on the price movement of crypto X. If crypto X goes up - I win, if it goes down - Joe wins. If my analysis turns out to be correct, I walk away as the winner of the wager with an extra $100 in my pocket. My returns in this case would not just be 10%, but rather, 100% (on the same $100).
In this scenario, the bet between Joe and I was a derivative contract. We agreed to give up something of value (our money) contingent on the price movement of an underlying asset (crypto X). There are many types of derivative contracts, including futures, swaps and forwards. Most of them trade on centralized exchanges or OTC (over-the-counter) and are generally utilized by sophisticated Wall Street investors - I’m talking large hedge funds and institutions managing billions of dollars. During the meme stock era of r/wallstreetbets, derivatives actually gained a lot of popularity amongst retail investors as well. Regularly, you would see people YOLOing their life savings on GME and AMC call options, which are also a type of derivative financial instrument.
To new investors, derivatives can feel like gambling. And I have to agree - to some extent, it absolutely is. Derivatives are a zero-sum game with clear winners and losers. For someone to make money, the counterparty needs to lose it. This is in stark contrast to investing, which is much more positive-sum - everyone can make money together. However, derivatives play a key function in keeping financial markets honest and efficient, and their importance often gets overlooked.
For starters, derivatives reduce transaction costs and starting capital requirements in the financial markets. To earn high returns, you don’t necessarily need to start off with large amounts of money. As long as your analysis is correct, your payouts can be enormous even with relatively low capital. This encourages market participants to conduct thorough analyses on assets in order to “gain an edge” over everyone else. Second, derivatives allow for short selling and price discovery. Without the existence of these products, market participants cannot short, or make downside bets, on securities. As much as wallstreetbets hates “the shorts”, it is a crucial function for properly pricing assets. Some of the most egregious frauds in business history have actually been sniffed out by short sellers (for example, Jim Chanos with Enron).
The crypto economy, similarly, requires these functions, but their existence is few and far between. The good news is that we are starting to see some of these products become mainstream. Just this past year, the first ever Bitcoin futures ETF was approved by the SEC. Many protocols are capitalizing on the opportunity as well, one of which is the topic of our discussion today: TracerDAO.
What is TracerDAO?
TracerDAO provides infrastructure for bringing derivatives onto the blockchain. Decentralized and on-chain financial products have not yet gone mainstream in crypto, and TracerDAO is one of the many companies leading the charge within this niche. Their flagship protocol is referred to as “Perpetual Pools”, which allows market participants to take leveraged bets with low-risk of liquidation.
TracerDAO adds a very unique spin on the collateralization design of leverage. Users on the platform deposit USDC to mint L-tokens (long position) or S-tokens (short position). Ownership of these tokens represent claims on the collateral of the protocol, and can be used as a substitute for buying/selling the underlying asset.
So, how does it all work?
Let’s imagine that the underlying asset is Ethereum. When the price of Ethereum goes up, some of the S-tokens in the pool are converted into L-tokens. The long-position of Ethereum now has more collateral (more L tokens in the pool), and it is reflected through price appreciation of the token itself.
In a scenario where the pool is 50% L-tokens and 50% S-tokens, a 10% transfer from one side will result in a 10% price appreciation for the other. But, whenever there is an imbalance in the system, it provides assymetric upside for the less collateralized side. This means that placing a 2x leveraged trade on the TracerDAO pool is significantly more advantageous than placing a 2x leveraged trade on the spot price of Ethereum itself. You might not make 200% returns in the optimal scenario, but your chances of being liquidated is much lower.
These TracerDAO pools have a lot of very useful applications in crypto. Most importantly, it allows investors to manage portfolio risk in a sophisticated manner. In traditional finance, complicated derivative products are reserved for institutions and these negotiations often happen behind closed-rooms. Democratizing derivatives, or at the very least, bringing it on-chain for everyone to see is a huge step towards transparency of financial markets.
To me, this is exciting, and I am even more excited to see what TracerDAO (or any other protocol working on financial derivatives) will have to offer us in the future.
Until next time.