In-Depth Analysis of Drift Protocol: Challenges and Evolution of On-Chain Perpetual Futures

After studying the Drift Protocol, I have a deeper understanding of Solana's relentless pursuit of the central limit order book ( CLOB ). Implementing perpetual futures automated market makers ( AMM ) on-chain is indeed fraught with challenges, leading to a necessity to embrace centralized market makers.

Although the virtual AMM created by Perpetual Protocol ( vAMM ) addresses the issue of leverage on the basis of spot AMMs, without the involvement of centralized market makers, the Perptual Futures AMM must rely on preset rules to deal with issues such as the absence of counterparties, insufficient depth, and price deviations. This leads to an exceptionally complex adjustable parameter and formula expression in Drift v1.

In order to cope with contract price deviations, Drift v1 has to define various market states (such as healthy market, sub-healthy market, etc.), assess the long-short imbalance situation, and formulate corresponding position liquidation and parameter adjustment plans. In contrast, traditional order books seem to be more concise and efficient. This also explains why Solana places such a high value on order book technology.

Drift later introduced a limit order feature, but the experience still differs from traditional order books. Currently, Drift's trading is supported by three liquidity mechanisms:

1. JIT Auction: Provided liquidity by market makers
2. Limit Order Book: Also provided liquidity by market makers.
3. AMM: When the market maker is not involved, liquidity is provided by Drift's AMM.

However, starting from August 7, Drift will completely abandon the AMM model and fully transition to centralized market makers. This decision stems from several core issues faced by vAMM:

1. Continuous funding rate loss, the protocol's insurance fund is essentially shorting volatility.
2. It is difficult to maintain price anchoring, requiring continuous subsidies to keep the futures price consistent with the spot price.
3. Path dependency issue, the greater the price deviation, the higher the maintenance cost.

It is worth noting that the founding project of vAMM, Perpetual Protocol, is also seeking new directions. They plan to adopt a more proactive market-making strategy in the V2 version, integrating the features of Uniswap V3, and attempting to solve the challenges of decentralized Perptual Futures through the combination of CLOB and AMM.

This transformation essentially shifts the vAMM, which originally relied on mathematical formula pricing, to a model where market makers actively quote prices. The risk has been transferred from the protocol level to the market participants.

Currently, the AMM model may be more suitable for spot trading. On-chain contract trading still needs to seek a balance between decentralization and centralization.

vAMM (Virtual AMM) Explanation

The vAMM of Perpetual Protocol adopts the same constant product formula X * Y = K as Uniswap.

Unlike traditional spot AMMs, vAMM adopts a two-layer structure: LPs act as collateral while the real assets are stored in a smart contract vault. Essentially, vAMM is a price discovery mechanism after users leverage.

For example:

1. Assuming the current price of ETH is 4000 USDT, the initial vAMM pool consists of 100 ETH and 400,000 USDT.

2. Alice used 100 USDT as margin and leveraged 10x to go long on ETH:

   • Alice deposits 1000 USDT into the smart contract as collateral.
   • Perpetual Protocol credited 10,000 USDT to vAMM
   • vAMM calculates the ETH that Alice should receive based on X * Y = K
   • Initial state: 100 ETH * 400,000 USDT = 40,000,000
   • After Alice's deposit: 40,000,000 / 410,000 ≈ 97.5609 ETH
   • Alice actually received about 2.44 ETH
   • vAMM updated to 97.5609 ETH and 410,000 USDT

3. Bob then uses 1000 USDT as margin to short ETH with 10x leverage:

   • Bob deposits 1000 USDT into the contract
   • Record -10,000 vDAI to vAMM on Perpetual Protocol
   • Bob shorted 2.4391 ETH
   • vAMM restored to 100 ETH and 400,000 USDT

vAMM adopts a funding fee mechanism similar to centralized exchanges, using a formula similar to that of the FTX exchange.

It is worth noting that vAMM has essential differences from contracts at traditional centralized exchanges. In centralized exchanges, each long position corresponds to a short position, and the exchange only provides a trading venue without assuming position risk. In vAMM, users are actually trading against the price curve rather than a real counterparty.

This leads to the need for the protocol to attract real counterparties through subsidies when facing a long-short imbalance. Therefore, the stability of the subsidy sources and the size of the capital pool become crucial, directly relating to the survival of the project. Especially in one-sided markets or during severe fluctuations, the capital pool is equivalent to shorting volatility, a strategy that typically makes small profits during normal times but incurs large losses during volatility.

Drift has innovated on the vAMM foundation of Perpetual Protocol, launching the dynamic AMM(dAMM). Its features include configurable parameters to address issues such as price deviation, long-short asymmetry, and insufficient depth. However, there are still some fundamental problems that cannot be solved.

In-Depth Analysis of Drift AMM

Drift adopts a dynamic AMM, which is an improvement based on vAMM, introducing the following configurable parameters:

1. Peg (Price Multiplier): Controls the deviation of the contract price from the spot price.
2. K: Control liquidity depth, affecting slippage.
3. Fee Pool: Mainly used to adjust Peg and K

These parameters, combined with the deviation of the oracle price (contract price) and the mark price (spot price), form a complex adjustment mechanism.

Peg (Anchor Multiplier)

Used for quickly adjusting prices to bring contract prices closer to the real market prices.

Price = ( underlying asset / valuation asset ) * Peg multiplier

Adjustment Plan:

• Check price deviation after each transaction
• If the threshold is exceeded, there are two options:

1. If the fee pool is sufficient, adjust the Peg directly.
2. If the fee pool is insufficient, compare the subsidy cost and the re-anchoring cost.

• Usually reduce the K value first, decrease liquidity depth, making it easier to push the price.
• After adjustment, the loss side accounts for the actual loss, while the profit side is supplemented by the fee pool.

K (Liquidity Depth)

Control the size of slippage. The larger the K value, the smaller the slippage. Since X * Y = K in vAMM is primarily used for pricing and not to represent actual LP assets, the K value can be adjusted.

In short:

• K-value controls the sensitivity of price to trading volume
• The absolute level of Peg adjustment price

Fee Pool

Not only a source of income, but also a market adjustment tool. Its main uses include adjusting the Peg value, replenishing profitable traders after adjusting the K value, and paying for funding rate imbalances.

Main source of income:

1. Taker fee (0.05-0.1%)
2. Liquidation Fee (50%)
3. Funding Rate Income

This model is highly dependent on the health of the fee pool, which may cause Drift to lose its advantage in terms of transaction fees. The more fundamental issue is that revenue growth is linear, while expenses may grow exponentially in extreme market conditions. In the long run, expenses may not be fully covered by revenue.

This also explains why Drift ultimately decided to abandon vAMM and embrace a centralized market-making model.

Summary

In the vAMM model, users trading Perptual Futures need to deposit margin, and the X * Y = K formula effectively transforms into a pricing curve. Drift attempts to better anchor the contract price to the spot price by introducing a Peg anchoring multiplier and an adjustable K value. However, the user position profits generated during this adjustment process need to be supplemented by the fee pool.

In the long term, during extreme market conditions, expenditures may grow exponentially, while revenues can only grow linearly, leading to a net subsidy for unbalanced positions in the protocol.

Currently, it seems that relying solely on mathematical formulas to control on-chain AMM paths is not feasible. The essence of Perptual Futures still requires the participation of centralized market makers to achieve counterparty balance. This also reflects the ongoing challenge of seeking a balance between decentralization and efficiency.