Automated Market Makers (AMMs) have paved the way for a new trading paradigm, enabling innovative DeFi primitives that support a wide range of protocols. While AMMs initially gained traction by facilitating spot trading for long-tail assets, they are now poised to revolutionize derivatives trading—including perpetual swaps, options, and volatility products—in decentralized finance.
Introduction
For many, Automated Market Makers (AMMs) represent the core innovation behind decentralized exchanges (DEXs). Unlike centralized exchanges (CEXs), which often exclude assets with low liquidity or rely heavily on traditional market makers, AMMs like Uniswap, Curve, and Balancer have enabled trillions of dollars in trading volume since their inception.
Their permissionless design allows anyone to create markets for new assets simply by providing liquidity. This has made DEXs ideal for trading low-liquidity or long-tail assets—a stark contrast to CEXs, which require manual integration for each new token.
However, most spot AMMs remain relatively basic, supporting only simple buy and sell orders. While some advanced spot AMMs and aggregators offer features like limit orders and deep liquidity, they still lack the ability to transform liquidity into more complex trading primitives.
In the product world, it’s often said that a new solution must be 10x better to displace incumbents and achieve significant adoption. Uniswap’s introduction solved the liquidity problem by allowing users to create markets for any ERC-20 token almost instantly.
Now, after years of battle testing, DEXs like Uniswap and Curve are ready to serve as building blocks for more advanced financial products.
The Uniswap Moment for Perpetuals and Options
Perpetual futures (perps), options, and other derivative products remain highly competitive and are still dominated by CEXs in terms of trading volume. However, by leveraging DeFi’s composability—the ability to stack and combine applications—these products have significant growth potential.
Most on-chain perpetual and derivative platforms support only a handful of assets, rely on oracles, and are susceptible to liquidity issues. Without sufficient liquidity, derivative exchanges cannot function effectively or attract users—a classic chicken-and-egg problem.
New protocols are now leveraging concentrated and constant-function AMM liquidity to power innovative trading products, including leveraged positions, perpetual futures, and options. In short, these protocols use AMMs like Uniswap as liquidity primitives to create new trading instruments.
- Constant Function AMMs: Liquidity is distributed infinitely across the entire price range (e.g., Uniswap v2, Balancer).
- Concentrated Liquidity AMMs: Liquidity is focused within specific price ranges (e.g., Uniswap v3).
Killer Use Case: Leveraged Exposure for Long-Tail Assets
The killer app for AMM-driven trading products is the ability to create perpetual futures, hybrid options, and volatility markets for illiquid or newly deployed assets.
Consider $PEPE, which reached a multi-billion dollar market cap within weeks during its peak FOMO period. At the time, traders repeatedly asked: “Where can I go long on $PEPE?”
Despite its popularity and billions in trading volume, only spot markets were initially available. Weeks later, a few exchanges began offering perpetual futures—and some even faced issues with liquidations and payments, a core challenge in perpetual exchange design.
With AMM-driven volatility products and derivatives, LPs can market-make options and perpetual futures at token launch, similar to how Uniswap enables instant spot markets.
There is enormous speculative demand for crypto assets, especially for leveraged exposure. Beyond speculation, these products also offer excellent tools for hedging LP positions.
How AMM LP-Enabled Trading Products Work
Protocols that offer AMM-driven trading derivatives operate on a simple hypothesis: providing liquidity in a CLAMM is mathematically similar to selling a put option. perpetual and volatility trading protocols build on this concept to create leveraged positions, perpetual futures, perpetual options, and other structured products.
Perpetual Options Mechanism Design
Protocols like Panoptic and Smilee leverage concentrated liquidity LPs to support their trading products—specifically, perpetual options and volatility trading. While each protocol has a slightly different architecture, they generally follow a similar high-level process:
- The protocol pulls concentrated liquidity from an AMM like Uniswap v3 (or its own AMM).
- Traders borrow these assets and redeem the underlying LP tokens for a single asset, simulating a directional bet constrained within the liquidity range.
- Since concentrated liquidity positions are 100% composed of one asset when out of range, traders pay fees to borrow and redeem the LP pair.
Example: Long ETH Trade
Suppose a trader wants to go long on ETH when its price is $1,000. They borrow an out-of-range USDC/ETH LP token worth $1,000 USDC (since the price has moved above the range, the LP holds 100% USDC). The strike price can be considered the midpoint of the LP range—say, $900.
The trader redeems the LP token for 1 ETH (worth $1,000). If ETH rises to $1,500, they can exercise the option by selling 1 ETH for $1,500, repaying the lender $1,000, and keeping a $500 profit.
If the trade moves against them and ETH falls to $800, the borrower now owes 1 ETH. They must acquire 1 ETH (now worth $800) to repay the loan.
Protocols like Panoptic abstract away much of this complexity. Users may need to deposit collateral, select position duration, choose strike prices, and pick a direction.
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Perpetual Futures Mechanism Design
Platforms like Limitless and InfinityPools operate similarly to perpetual options but allow users to deposit collateral merged with borrowed LP. The required collateral and leverage are determined by the distance from the spot price.
If a trader borrows a below-range LP token, they can sell one of the underlying tokens to create a directional leveraged bet. The key difference is that users deposit collateral to cover maximum loss if the trade moves against them.
Both Limitless and InfinityPools claim to offer leverage up to hundreds or thousands of times, depending on the distance between the range and the current price. If a trader incurs losses, the protocol closes their position and uses the collateral to compensate LPs.
Market Opportunity: Crypto Trading Derivatives
Traditional Finance Market Size
According to SIFMA Asset Management, the U.S. equity market dominated globally in 2023, accounting for 42.5% of the $108.6 trillion global equity market cap—approximately $44 trillion.
The derivatives market is estimated to have a notional value exceeding $1 quadrillion, though some argue this figure may be inflated. The net value of all derivatives contracts was significantly lower—$12.4 trillion in 2021.
In traditional finance, derivatives trading far exceeds spot trading. The same is true in crypto, but most volume occurs on centralized exchanges.
Crypto Spot vs. Perpetual Futures Trading
In Q1 2023, derivatives accounted for 74.8% of the total crypto trading volume of $2.95 trillion. Spot trading on CEXs and DEXs represented 22.8% and 2.4%, respectively. Leading CEXs like Binance, Upbit, and OKX dominated the derivatives market.
According to a CoinGecko report, derivatives trading volume grew 34.1% year-over-year, while spot trading on CEXs and DEXs grew by 16.9% and 33.4%, respectively.
As of July 2023, 74% of all crypto trading volume was conducted with leverage.
Innovative volatility trading platforms like Panoptic, Infinity Pools, and Smilee are pushing the industry forward by offering oracle-free, liquidation-free, and high-leverage trading. By leveraging concentrated liquidity, AMM LP trading products eliminate common weaknesses like oracle reliance and liquidation risks.
Risks and Challenges
Despite their promise, AMM-driven trading products come with risks.
Smart Contract Risk
Since these products manage LP tokens or require user deposits, smart contract vulnerabilities or bugs pose significant risks.
Credit Liquidity Risk
Some protocols, like Gammaswap, have raised concerns about “credit liquidity risk”—the possibility that LPs cannot pay winning positions due to over-leverage or insufficient liquidity. In Uniswap v3, low-liquidity ticks can lead to high slippage even for stable pairs.
Unlike traditional finance, there is no central entity like the Federal Reserve to inject liquidity into DeFi markets. The absence of oracles for liquidation adds further complexity.
Panoptic mitigates this risk by requiring pool creators to deposit small amounts of both tokens across all price ranges. These deposits cannot be removed by traders and ensure baseline liquidity.
Complexity and User Adoption
Perpetual futures are relatively easy for crypto investors to understand: users simply open long or short positions with a click. Options and perpetual options introduce additional complexity—Greeks, strike prices, and traditional options knowledge—which may hinder adoption, especially among retail traders.
Moreover, volatility trading adds another layer of complexity to the user experience. Given that crypto already faces adoption challenges, highly complex products may struggle to gain traction due to their financial sophistication.
Frequently Asked Questions
What are AMM-driven perpetual futures?
AMM-driven perpetual futures are leveraged derivative products that use liquidity from automated market makers like Uniswap v3 to enable long or short positions without traditional oracles or order books.
How do LPs benefit from supporting derivatives markets?
LPs earn not only trading fees but also volatility premiums and funding rates. This provides an additional revenue stream beyond standard AMM yields and helps offset impermanent loss.
Can these products be used for hedging?
Yes, traders and LPs can use perpetual futures and options to hedge their spot positions against market volatility, reducing overall portfolio risk.
What is credit liquidity risk?
Credit liquidity risk refers to the possibility that liquidity providers may be unable to cover winning trades due to insufficient liquidity or over-leverage in the system.
Are AMM-driven derivatives available on all DEXs?
Most current solutions are built on Uniswap v3 due to its concentrated liquidity features. However, newer protocols are exploring compatibility with other AMM models.
How do perpetual options differ from traditional options?
Perpetual options have no expiration date. Traders pay continuous funding fees to maintain their positions, similar to perpetual futures contracts.
Conclusion
Perpetual futures and options have firmly established themselves in the crypto ecosystem. It’s only a matter of time before they evolve into mature products that appeal to both traders and LPs.
In the coming months, many of the protocols mentioned will launch beta versions and live products. The next evolution of on-chain derivatives will be the ability to long or short any asset with leverage. The question, “Where can I long PEPE?” will be answered by providing leveraged liquidity trading channels for mid- and long-tail assets.
AMM-driven trading products are paving the way for a new paradigm—one that could enable entirely new DeFi primitives for options, perpetuals, volatility trading, and other leveraged products. The trading experience is set to improve significantly, potentially rivaling existing solutions in the market.