Decentralized Derivatives. How dYdX Enables Trustless Margin Trading
Decentralized trading platform dYdX is pioneering trustless derivatives trading on the Ethereum blockchain. Read on to learn more.
When decentralized trading platforms first emerged, the focus was exclusively on spot trading. Since then, however, the decentralized finance market has evolved to witness the emergence of decentralized derivatives trading protocols.
Arguably the most cutting-edge decentralized derivatives trading platform is dYdX, which was launched in 2018 to allow anyone to lend, borrow, and margin trade cryptocurrency in a trustless manner.
In this article, you will learn about decentralized derivatives trading and how dYdX makes it a possibility on Ethereum.
dYdX: A Decentralized BitMEX
dYdX is a decentralized financial protocol that provides trustless spot and leveraged trading, borrowing, and lending on the Ethereum blockchain.
The California-based company, led by former Coinbase engineer Antonio Juliano, was founded in 2017 to build a decentralized trading platform for advanced financial products.
The main challenge with centralized exchanges is fund security. If you have been in the crypto markets for a while (or even just a few months), you will have heard of large-scale exchange hacks where millions of dollars in user funds were stolen. That is possible because centralized exchanges have single points of failure that can potentially be exploited.
Decentralized exchanges, on the other hand, leverage smart contracts and non-custodial fund storage to mitigate the risk of funds being lost or stolen because of an attack from nefarious actors.
Decentralized exchanges don’t hold user funds, which means they cannot be stolen from the exchange. That is precisely what makes decentralized trading platforms, such as dYdX, so appealing to experienced traders.
dYdX settles trades on the blockchain but uses an off-chain matching engine to ensure the same execution speeds traders are used to on centralized exchanges but with the security of holding funds in a non-custodial manner.
What is Margin Trading?
In addition to spot trading (converting one digital token for another), dYdX offers margin trading to enable crypto traders to execute more advanced trading strategies.
Margin trading, also known as leveraged trading, allows traders to borrow funds from a third party to take larger positions. Not only does this allow professional traders to amplify their trading profits (and losses!), but it also allows retail traders to take larger positions than they would normally be able to with only a small amount of initial capital.
If you are bullish on Ethereum, you could place a 5x leveraged trade on ETH/USDC with an initial margin of $1,000. In that case, you would have $5,000 worth of exposure to ETH/USDC. If the price would increase by 10%, your position would be up by $500 (instead of only by $100), which would be a 50% ROI on your trade if you were to close it out at that point.
Conversely, if your bullish conviction turns out to be wrong and the price of ETH drops by $10 against USDC, the value of your $1000 5x leveraged position would drop to $500. A loss of 50%.
To start trading on dYdX, all you need to do is connect your Ethereum wallet. The simplest way to do that on mobile is to use Trust Wallet’s in-app DApp Browser.
Alternatively, you can use WalletConnect to log onto the web-based version of dYdX.
Margin trading also enables traders to short assets that they believe will underperform.
Short selling an asset involves borrowing an asset to sell it and then buying it back later (hopefully at a lower price) to make a profit when the asset drops in value.
Ethereum bears, for example, can use dYdX to short ETH against USDC or DAI (with up to 5x leverage) if they believe ether will drop in value in the coming days.
What Are Perpetual Futures Contracts?
In 2020, dYdX also introduced perpetual futures contracts to its product suite to provide professional traders with a new avenue to take leveraged positions in a decentralized manner.
Perpetual futures contracts, also known as perpetual swaps or perpetuals, are financial derivatives akin to futures contracts but with the main difference being that there is no expiry date.
A futures contract is an agreement to buy or sell an underlying asset for a specific price at a predetermined time in the future. So, instead of settling upon the purchase or sale of a futures contract, it settles at the expiry date.
Futures were initially intended for the commodity markets for farmers looking to hedge against adverse price movements in the value of their crops. However, the futures market has since evolved to become a thriving marketplace for speculators looking to go long or short an asset using leverage.
As the name suggests, perpetual futures contracts have no expiry date.
They also typically trade closer to the spot rate than traditional futures. The reason for that is that they rely on a funding mechanism, called the funding rate, which consists of regular payments between buyers and sellers.
When the funding rate is positive (i.e., when the contract trades above the spot price), traders who have placed long positions have to pay traders who are short the funding rate. If the funding rate is negative, those who are short pay those who are long.
The main idea behind perpetual crypto futures contracts is to enable seasoned traders to put on leveraged trades on digital assets that they can hold for a longer period of time without actually owning the underlying asset.
dYdX was the first protocol to launch decentralized perpetual contract markets when it introduced its BTC/USDC Perpetual in April 2020.
Opportunities & Risks of Trading with Leverage
Whether you are margin trading or speculating on price developments using perpetual futures, the opportunities and risks are very similar.
The main opportunity is clear: the potential to increase trading revenues. Trading with leverage or derivatives that enable you to leverage your position provides traders with the ability to increase the sizes of their positions to potentially amplify returns.
The flipside of the coin, however, is that losses are also amplified and can occur with the blink of an eye if high leverage is put in place.
To avoid excessive risk-taking by inexperienced traders, dYdX has limited its leverage for margin trading to 5x and for perpetual futures to 10x. However, that does not mean that novice traders can’t lose money quickly should the market move abruptly in the opposite direction.
An additional benefit of leveraged and perpetuals trading is that it enables traders to enter into short positions. In other words, it allows traders to bet on a price drop of an asset.
For example, if you are bearish on Ethereum, you could sell ETH/USDC with 5x leverage and make a trading profit if the price of ETH drops against the dollar.
Trading using margin means borrowing funds to increase the size of your position. Therefore, margin trading incurs a borrowing fee (typically paid daily.) **So, the longer you hold your leverage position, the more interest fees you will pay for borrowing margin.
In the case of perpetual futures contracts, traders either pay or receive the funding rate. If you find yourself paying the funding rate for longer periods of time, this will affect the profitability of your trade.
How to Earn Interest on dYdX
If you have ever looked through DeFi lending rates aggregators, you may have noticed dYdX on the list. That is because the decentralized protocol also allows users to borrow and lend Ethereum-based assets.
Earn interest on digital assets on dYdX is arguably the easiest than on any other DeFi platform.
As soon as you deposit funds into the protocol on the ‘Balances’ page, you will start to earn interest.
Yes, that’s all it takes! And you will earn interest every second that your funds are held in the protocol.
The interest on deposited assets is paid by borrowing (primarily margin traders) on the platform. Since borrowing on dYdY is only able with collateral, should borrowers fail to repay or the value of their collateral drops below a certain threshold, their collateral is automatically liquidated to protect lenders.
dYdX has been able to replicate the popular crypto derivatives offering from leading centralized exchanges such as Bitfinex and BitMEX but in a secure, transparent, and trustless manner, making it — in many ways — superior to its centralized peers.