Shield - The first on-chain perpetual options

Nick Sawinyh on 09 Aug 2021

Today, we talked with Charles about his journey from the Fintech industry to DeFi and how Shield is building a one-of-a-kind decentralized protocol for future derivatives infrastructure.

Disclosure: This article was sponsored by Shield protocol

Hello! What’s your background, and what are you working on?

Hey, I’m Charles Smith from Shield protocol. I’m a serial entrepreneur in the Fintech industry and a founding member of the world’s largest food delivery company. I’ve worked in crypto for three years and founded centralized exchange JustEX in 2018. Now I’m building Shield - decentralized, borderless, and trustless protocol for trading derivatives. I think Shield is quite unique compared to the other potential competitors with next important features:

Shield’s perpetual option

  • The first long-term on-chain options without the effort, risk, or expense of rolling positions

For options traders

  • Exercise anytime with no expiration date
  • Long-term exposure without the need to roll position, decrease operational work, and risk
  • Concentrated liquidity to avoid liquidity fragmentation by different expiration dates and prices

For perpetual traders

  • Maximum trading loss is the daily funding fee
  • On-chain leverage from 25x to 500x

It is difficult to counteract traditional centralized exchanges under the current base layer limits. Uniswap’s great success was not due to providing a better spot trading experience than the current CEX. Rather a permissionless, very low-cost solution that met the demand for long-tail asset offerings that the CEX could not. Essentially, the success came from tapping into a new unmet market. We believe the only way to break the ice is to apply the features of blockchain technology to meet the needs that traditional finance cannot. That’s why we chose to use the perpetual option as our first product to enter the market.

What’s Shield’s backstory?

Before entering the DeFi industry, the Shield founding team worked primarily for their respective centralized exchanges.

In June 2020, Charles began to turn his attention to the DeFi industry, rapidly returning to growth after the March selloff. After talking to the founder of a tier 1 crypto VC fund. 1inch was the product of greater interest at the time. In July 2020, 17 days after Curve and 1inch partnered, TVL quickly surpassed $1 billion. Then, in September, after comparing Compound with traditional credit systems he had designed many times before, Charles realized the revolutionary qualities of DeFi. He immediately shared it with his long-time friend Dr. Lucas, a double Ph.D. in mathematics and financial engineering, taught at a university for many years, and is a top derivative design expert. Unfortunately, DeFi derivatives were almost a blank slate at the time.

However, there are segments within the vast derivatives track, such as perpetual contracts, options, and structured products. Perpetual contracts are the most significant market but also the most demanding for trading systems. After analyzing the core needs of perpetual contract users, we concluded that the current blockchain infrastructure makes it challenging to create DEX products that can compete with centralized perpetual contracts. On the contrary, options and structured products require a trading system that can be satisfied by current public chains, but the market for both is relatively small. So, we thought we could design a perpetual options product that would include both perpetual contracts and options traders, and Shield was born.

Currently, there is no real dominator; in this huge market of Derivatives Dex. Leaving a great opportunity to create the largest piece of DeFi Lego.

The following challenges still exist for the decentralized derivatives product:

  • Block interval time issues cause a domino effect, delaying on-chain transactions resulting in poor availability of pips.
  • Product is dependent on whether liquidity mining incentives can consistently sustain the cost of LP capital and market-making risk.
  • Subject to on-chain matching capabilities, DEX currently only offers leverage of up to 25X
  • Current DeFi derivates products lack incentives designed for market educators. Derivatives are a sophisticated and high-risk instrument. It would be unethical to have a derivatives protocol without the proper engagement of brokers to provide educational trading services.

Considering the challenges above, Shield expects to solve these problems through the following innovations:

  • Precise pricing for perpetual options on-chain: Applying mathematical knowledge of stochastic processes, volatility, and partial differential equations with initial margins, Shield finds the exact solution of Shield perpetual option funding fees. Meanwhile, Shield applied the nonlinear cutting process and succeeded in implementing the pricing on-chain by replacing the exact solution of the nonlinear pricing model with a linear computation to find an approximate solution.
  • Dual liquidity pools: The dual liquidity pool allows the private pool to hedge the market making risk, while the low-risk public pool can accommodate huge liquidity to guarantee abundant liquidity on the market
  • On-chain random matching engine: Shield pioneered the first on-chain random order taking algorithm. Newly opened orders are randomly generated by two random factors: the hash of the block and the block time, and the remainder is taken using the current private pool length, i.e., the order is assigned to the corresponding private pool first. If the private pool is critical or the available balance is insufficient, it is polled sequentially until an available private pool is encountered.
  • Liquidator and decentralized Brokerage system designed based on game theory: Liquidator compete to receive 150% of the gas expense as arbitrage rewards while decentralized brokerage system incentivize brokers to bring a steady stream of traders to the Shield network through education and referrals

What went into building the Shield?

From the initial market research and idea formation to the upcoming launch of the main website, the period in between should span about eight months, that is, from October 2020 to now.

2020 June was the first time I paid attention to Defi, 1inch was the more attention to the product at that time, and then in 2020 July, Curve and 1inch cooperation and TVL reached a billion dollars, so this again aroused my interest and want to understand this market further. Then in September, my team and I compared traditional fintech with Compound and discovered the value of defi and that the only significant gap in defi was in financial derivatives. Hence, I had the idea to plunge deeper into the derivatives industry.

Derivatives space consists of perpetual contracts, options, and structured products. And perpetual contracts is the largest market. Its competitors are centralized exchanges, but if we only limit our products to perpetual contracts, it is challenging to counteract traditional centralized exchanges with the current technology. There is no disruptive user experience. However, the market for options is smaller. Still, it can be done on the current blockchain infrastructure, so we combine perpetual contracts and options together to make an exceptional product to capture a more extensive market base.

We apply mathematical knowledge of stochastic processes, volatility, and partial differential equations with initial margins to find the exact solution of Shield perpetual option funding fees. At the same time, we applied the nonlinear cutting process, successfully implemented the pricing on-chain by replacing the straightforward solution of the nonlinear pricing model with a linear computation to find an approximate solution. After hundreds of data back-testing, the error between on-chain pricing and exact pricing falls within 5%. This breakthrough in the pricing model with the exact solution is also of great significance in the financial engineering academic community.

We have worked with Slowmist and Peckshield to complete the security audit, but after the audit report, the code has been iterated a lot for BSC version release, and the iterated part of the audit will be added in August after the public testing is complete, and the deployed version of the audit report will be issued.

What’s your business model?

Shield captures value through 1% of trading fees and returns 100% of the revenue to the maintainers of the decentralized network (value creators) through the innovative Swap&Burn mechanism.

To explain Swap&Burn further, the value of the SLDs mined is redeemed by Swap&Burn contracts (as shown above). Shield generates a repurchase price by making 10% of the total SLDs outstanding always equal to 100% of the repurchase pool value (derived from 90% of the transaction fees).

  • When the secondary market price of SLDs is higher than this price, then the value of the swap&burn pool keeps growing because no one comes to swap.
  • When the secondary market price falls below this price, someone will go to the secondary market and buy the SLDs to redeem the contracts for the difference, thus ensuring a minimum price in the secondary market (which is similar to the price valued by PE in stock valuation).

While the transaction fees for the left Swap&Burn pool will grow with business without a cap on growth, the SLD pool in circulation on the right will continue to deflate as destruction and mining rewards are cut in half. In the long run, this pass-through design guarantees a bullish coin price.

What are your goals for the future?

The future of Shield is to create an easy-to-access decentralized derivatives protocol without trust and regional boundaries. Shield 2.0 onwards, we will abstract the oracle, dual liquidity pool, brokerage system, and liquidator as components of the protocol. Anyone can quickly build a derivatives service based on these standard components.

What are your future thoughts for the DeFi market?

In 2020, the DeFi market, dormant for more than two years, finally exploded under the global liquidity glut macro background. As a result, bitcoin mining halved to kick off the digital asset bull market and micro innovations such as liquidity mining and AMM automatic market makers. As a result, the DeFi space of decentralized stablecoins, lending, and spot exchanges made substantial leaps forward and gradually gave birth to many leading projects.

The success of these DeFi projects has led us to recognize the revolutionary core feature of DeFi:

  • The Non-custodial assets and transparency of transactions: assets no longer need to be placed in the custody of third-party trusted institutions (not your keys, not your coins), while all transactions are authentically traceable, eliminating human mischief.

  • Trustless: trust is no longer limited by brand but comes from open source and code.

  • Disintermediation: the removal of centralized institutions that provide intermediate information and credit (tax intermediaries), returning 100% of revenue back to the maintainers of the decentralized network (value creators).

In the long term, these revolutionary qualities will drive a paradigm shift in traditional financial markets. Put simply – DeFi is eating CeFi and TradFi with its competitive edge and appeal and becoming an unstoppable trend in the process.

Where can we go to learn more?

About the author
Nick Sawinyh
Nick Sawinyh is an LA-based crypto entrepreneur. After having spent over four years in the blockchain industry, Nick founded DeFiprime in 2019, with the idea to provide information about emerging DeFi ecosystem. He owns modest amounts of various cryptocurrencies.

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