A Letter from the Founder of Shield Perpetual Option Protocol
September 23, 2021
When Shield Mainnet Beta goes live, I’d love to have a chat with you shielders, those early supporters who have been assisting us along the way. Let us share more behind-the-scenes stories about Shield protocol, how we position ourselves, and how we confront and overcome challenges.
I believe that if it hadn’t been for COVID-19, the exchange where Dr. Lucas worked would have continued to expand in international markets, and the Fintech company I founded to serve the Southeast Asian market would not have encountered such difficulties. I closed the office in Ho Chi Minh City in June 2020, realizing that the epidemic was unlikely to improve in a short period of time. By chance, a friend who recently launched a crypto fund told me that he was bullish on 1inch and Curve. Soon after, 1inch integrated the Curve protocol for only 17 days, and Curve reached a TVL worth $1 billion.
For a continuous entrepreneur who has been in the technology industry for over ten years, this news made me keenly aware that something significant must have occurred in this field. Because I had previously led teams to develop large loan systems and was familiar with traditional loan systems. I realized that a decentralized lending protocol like Compound could not exist in a centralized world. I’m thrilled to be able to share this discovery with Dr. Lucas, my good friend, for many years. He taught at a university and designed derivatives products for traditional derivatives exchanges before entering the crypto market.
After hearing what I had to say, he believes that the field of decentralised derivatives will produce paradigm products as well. As a result, after a 10-hour brainstorming session, the original idea of Shield was born on a note of fewer than 800 words.
What problem we try to solve
Although Friedman’s book “The World Is Flat” described how globalization flattens the world, if you travel to Africa or Southeast Asia today, you will find that the world is still more rugged than flat in many ways. Just as many countries lack a highway system, they cannot build a commodity and foreign exchange derivatives market capable of escorting the country’s fiat currency trade. Insufficient foreign exchange reserves and administrative control have made access to the major global derivatives markets difficult. This increases the risks of doing business in these countries, which stem from risks such as exchange rate losses, similar to the issues my fintech company encountered in Southeast Asia.
With the rise of blockchain technology and DeFi, we saw the possibility of creating a non-profit derivatives trading market that does not require asset custody, trustless borders, or global access so that a brand-new derivatives service infrastructure can be provided to a wide range of countries and regions that lack the ability to build their own derivatives market.
Perpetual Options is not planned
After considering Shield’s mission, we rolled up our sleeves to work on the layer mechanics. We began frantically looking for information, studying codes, and meeting with DeFi experts. However, due to Ethereum’s low throughput (low TPS, high GAS fee, and lack of computing power), we quickly realized that we couldn’t build high-availability futures or perpetual contract products on Ethereum Layer 1.
There were three potential options available at the time:
- Self-developed public chain.
- Waiting for layer 2 and other high-performance public chains to go live.
- Financial engineering innovation to compensate for the lack of public chain performance.
Choices 1 and 2 necessitate significant investment and uncertainty, so we must address infrastructure bottlenecks through financial engineering innovation.
Challenge 1: Price latency, poor price availability
Perpetual contracts require a high level of price availability when opening and closing positions. It takes Ethereum 14 seconds on average to obtain a price. For the digital currency market, with its volatile price fluctuations, this means that in extreme cases, there may be a dilemma between opening and closing a position. However, the option without the risk of margin liquidation has become a more suitable choice because of its low price sensitivity.
Challenge 2: Traditional options are difficult to popularize, making it difficult to meet trading needs.
The new problem, in particular, is that traditional European/American options are complex and difficult to understand and thus cannot be widely popularized. As a result, for the agreement to meet a broader range of trading needs, we considered whether options could be simplified, and there is no longer a fixed exercise date, as in a perpetual contract. As a result, the design concept of perpetual options was born.
Challenge 3: Pricing perpetual options on-chain
Because there are no previous formulas that can be directly applied to the pricing of perpetual options, we must first apply mathematical methods such as volatility, stochastic processes, Monte Carlo simulation, partial differential equations with initial boundary value, and other mathematical methods to obtain accurate solutions (Please refer to the details here). Fortunately, we have analytical solutions to partial differential equations. However, in EVM, calculating this exact solution is nearly impossible. To complete pricing on-chain, we must convert the precise nonlinear solution to an approximate linear solution and calibrate the error within an acceptable range.
Challenge 4: How to obtain sufficient liquidity and control the risk of liquidity provision (market-making).
We appear to have overcome the most difficult challenge, and the next question is how to make this market liquid. Due to the high gas fee, the traditional order book model is obviously unable to operate on-chain, and the peer-to-pool model has become a more suitable solution instead. However, unlike the liquidity pool provider in spot trading, which only bears temporary losses and multi-token exposure risks, the liquidity pool of derivatives bears a significant risk of loss. We created the first dual liquidity pool model to allow liquidity providers to hedge market-making risks and to reduce the risk of non-professional users participating in liquidity provision.
The dual liquidity pool consists of a public pool and private pools. The public pool is a unified reserve liquidity pool where anyone can provide liquidity as a supplement when the private pool has insufficient liquidity. Private pools are reserved for professional market makers and take priority over public pools. Each wallet address corresponds to a private pool, making it easy to obtain position information and hedge risks.
In addition to these major challenges, we have solved several other issues, such as an on-chain random order matching algorithm, a decentralized brokerage system, and a decentralized buyback and burn mechanism. Shield 1.0 was born free of the hassles of rolling positions for options traders and the risk of margin liquidation for perpetual contract traders.
Decentralized DEX or Decentralized Trading Protocol
We started with a vague vision of building a decentralized CME global derivatives marketplace, similar to the products developed by most decentralized derivatives projects we’ve seen: bringing CeFi to DeFi. However, as development progressed, we were struck by the inherent openness and composability of blockchain technology, as well as the thought that at least thousands of structured derivatives could all be reused in the same derivatives financial engineering architecture, and we shifted our goal from a single product and marketplace to a broader set of trading protocols.
Although the degree of decoupling and protocol attributes of Shield 1.0 are not yet sufficient, we prefer to think of Shield Perpetual Options as the Shield derivatives protocol’s first attempt. We will continue to iterate and upgrade until the world has a secure, robust, developer-friendly decentralized derivatives trading protocol.
ShieldDAO and Decentralized Governance
As previously stated, it was the decentralized lending protocol that struck us as unique in a centralized world. We believe in a new order that eliminates the central “tax collector.” We believe nothing can lead to such widespread global trust other than open-source and decentralized. That is why we are constantly striving to contribute our wisdom to solving the world’s problems and dedicating the Shield protocol to value creators in a completely decentralized manner.
As a result, Shield was born on the first day of its existence, eschewing the traditional corporate or foundation form of organization. ShieldDAO is the only cloud form of organization for the Shield Protocol that anyone can join, and it will never belong to anyone or become another business empire.
To be sure, the development team is still hosting the early maintenance of the protocol for the time being, given the current complex derivatives trading requirements and rapidly changing blockchain infrastructure. However, once it is stable, it will be fully handed over to community governance.
What’s next in crypto
The crypto world has ushered in a big explosion since 2020. Looking at the current evolutionary trends in the industry, there are two fundamentals worth attention.
1) Web 3.0
Web 3.0 will not simply be a replacement for the current Internet; rather, it will give birth to a new set of computing networks based on a completely different underlying design philosophy than the traditional Internet. This network is based on the concept of decentralization. Whether it’s decentralized computing power (miners) or decentralized storage (nodes), decentralized operating systems and databases (public chains), or decentralized applications (Dapp). With more capital and talent, it is almost certain that Web 3.0 will come regardless of anyone’s will. In addition to DeFi and NFT, we will witness what Crypto Native applications will be born on this new computing network and how these applications will impact the world.
2) Relations of production network
The low cost and credibility of value issuance and circulation are significant reasons why blockchain technology has the potential to change relations of production. Due to the high cost of credible recording values in the absence of blockchain technology, humans made the share-based system of capital distribution the primary form of production relations organization. With the advancement of blockchain technology and DAO, I believe the future will see the emergence of a new production system distinct from the share system. In this brand-new production relationship system, founders can raise a small amount of initial capital from the market, and once the platform goes live, the platform revenue will be distributed to the value creators based on their contributions rather than early investment.
As I mentioned earlier, my journey is not yet complete. Every challenge I’ve overcome has strengthened my commitment to Shield’s vision of creating a decentralized derivatives infrastructure that is easily accessible to anyone and is built on blockchain technology. However, several important milestones must be met before we can realize our vision:
- Stabilize Shield 1.0.
- Launch standard perpetual contracts built on the Shield protocol and based on L2 technology.
- Decouple liquidity pool, liquidation, and brokerage systems in order to launch Shield 3.0- a highly composable protocol for developers and achieve fully decentralized governance for the Shield protocol.
I encourage you to get involved and become a community member, builder, and ecosystem contributor to ShieldDAO（https://t.me/shield_DAO). Your efforts will make a substantial difference in the DeFi space; join us to accomplish something challenging but meaningful at the same time.
Last but not least, if the world has a criterion for judging justice, I believe it will be whether it is conducive to making human society a better place.