First ideated by Vitalik Buterin in 2017 and then pioneered in production by Uniswap in 2018, automated market makers (AMMs) mark the latest great vault forward in the evolution of spot trading markets.
Why? These systems, which underpin DeFi’s rising wave of decentralized exchanges (DEXes), are open and efficient for anyone with a crypto wallet and thus democratize access to trading and market making in ways the world’s never seen before.
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Yet beyond opening up spot markets to anyone, anywhere, and anytime, AMMs represent the next step forward in the history of derivatives markets as well. Let’s explore why by first considering how we got to where we are today.
A brief history of derivatives
- Scholars trace the birth of commodities futures contracts back to ancient Mesopotamia. For instance, Hammurabi’s Code (c. 1750 BC) references a futures-like legal arrangement from that era.
- From there, similar commodities futures offerings then spread to Egypt and Rome, and later through the Byzantine Empire and around the Mediterranean.
- In the 1500s A.D., derivatives trading picked up steam in Europe’s Low Countries and in the 1600s spread throughout Western Europe, particularly England and France and later Germany.
- In the 1700s and 1800s, banks began to get involved and lead derivatives trading activities. Then in the mid-19th century, U.S. merchants wanting to guarantee buyers and sellers for their goods led to the creation of the Chicago Board of Trade (CBOT), which became the world’s first dedicated derivatives market.
- After derivatives regulations started to formalize in the late 1800s, better efficiency and lower costs brought in derivatives speculators like never before. With this liquidity surge came a surge of demand for new types of increasingly complex financial instruments, in turn paving the way for modern derivatives.
- Since then, the invention of the computer and later the internet have revolutionized derivatives markets and led to a Cambrian explosion of efficient and lucrative activity around them. Indeed, some estimates place the market cap of the contemporary derivatives market at over $1 quadrillion USD!
Where AMMs fit in
In the wake of the U.S. housing bubble popping in 2006, interconnected exposure created by institutional U.S. mortgage market derivatives were a big contributor to the 2007-2008 global financial crisis.
This crisis influenced Bitcoin creator Satoshi Nakamoto toward decentralization in Bitcoin’s development, as famously suggested by the message they emblazoned in the inaugural blockchain’s inaugural block: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”
Then the dream of Bitcoin gave rise in 2015 to the dream of Ethereum, the pioneering smart contract platform purpose-built for supporting a wide variety of decentralized applications, not just decentralized currency.
As such, the rise of Ethereum paved the way for the dapp era and the rise of decentralized finance (DeFi), of which the launch of Uniswap in 2018 proved to be a major catalyst. Uniswap’s AMM system, which uses smart contracts to automate price matching between traders instead of relying on a counterparty, now rivals centralized exchanges in popularity and volume and has inspired countless spinoff DEXes.
Related: Why Invest in an Index?
Synthetix, a synthetic assets protocol, launched soon after Uniswap and introduced to DeFi the possibility of on-chain derivatives. From then on, derivatives have become an increasingly important and active area of interest in DeFi.
That said, in recent times we’ve notably seen a growing wave of projects combining on-chain derivatives offerings with AMM systems to create the world’s latest iteration of derivatives markets. In other words, derivatives markets that for the first time ever don’t need to rely on a counterparty and are censorship-resistant, permissionless, and low-risk.
Zooming in, some examples of newer DeFi derivatives projects that have developed custom-built AMM systems include:
- CompliFi — derivatives exchange
- Hegic — options exchange
- MCDEX — perpetuals exchange
- Pendle — interest rate swaps exchange
- Premia — options exchange
- Siren — options exchange
Related: Why Invest in an Index?
Why AMMs for modern derivatives: the CompliFi case study
CompliFi is an interesting example of a new DeFi derivatives project that started out purely as a derivatives issuance protocol, like Synthetix, but is now pivoting to an AMM system in its V2 upgrade.
However, traditional AMMs aren’t suitable for derivatives trading because they don’t account for things like maturities and settlements. And as a plain issuance protocol, CompliFi’s V1 derivatives weren’t well-suited for market making.
For V2, then, the CompliFi team has created a customized AMM implementation designed to provide a simple, Uniswap-like experience for both derivatives buyers and sellers.
As such, this AMM allows CompliFi V2 to offer users liquidity pool-based derivatives with an array of strikes and maturities and with automated issuance and settlement, all handled transparently on-chain. This model allows CompliFi to do away with margin calls and liquidations, as all of the project’s derivatives are always fully collateralized therein.
Additionally, CompliFi’s deployed on the Polygon sidechain to ensure its traders and underwriters can enjoy fast, low-cost transactions. So here we have an example of a decentralized derivatives market that is affordable, open to anyone, performant, and low-risk. This is what the next modern derivatives markets look like, and AMMs are what’s making this historical advance possible.
Disclosure: We’ve partnered with CompliFi to help educate and inform the community about derivatives. As always, we’re committed to providing the entire community with quality, objective information, and any opinions we express are our own.
