The rise of Solana's perpetual protocol

Article Author: Messari Researcher & Dustin Teander
Article Translation: Block unicorn

Solana has garnered significant attention from investors in the last quarter. SOL has risen by 50% in the past 30 days and nearly 500% against the dollar in the past 90 days (up 24% and 249% against ETH, respectively). In many ways, the price discovery has been healthily driven across various sectors—announcing a $100 million gaming fund, Brave announcing native integration in web3, Reddit investing $100 million in social media, Neon Labs raising $40 million to introduce EVM infrastructure, and of course, Solana's DeFi ecosystem, which has achieved a 4x expansion in TVL since September.

While Solana has certainly developed many growth catalysts recently, how does the ecosystem perform according to the narrative from earlier this year? One of them is Solana's potential as a network capable of supporting a large volume of trading activity. Perhaps influenced by some of the largest investors in the ecosystem, including Alameda and Jump Capital. Compared to other ecosystems, Solana now has a relatively high concentration of derivative-focused protocols.

Let’s take a look back at Solana protocols, focusing on one of the crypto community's favorite trading products—perpetual contracts.

For some simple background, a perpetual contract is a futures derivative that does not require contract rollovers, providing continuous future exposure to a specific market with a single product. For traders, it is a straightforward way to gain leveraged futures exposure to an asset without the inefficiency of actually purchasing the underlying asset. Thus, it is the most traded product in cryptocurrency to date. In October, the perpetual nominal trading volume of centralized exchanges (CEX) for just BTC and ETH markets reached $2.7 trillion, while the trading volume of all CEX spot markets reached $1.25 trillion.

The decentralized exchange (DEX) perpetual market still lags behind spot trading volume. For example, in the past 24 hours, the leading DEX perpetual protocol dYdX had trading volume close to $3 billion, while all DEX spot markets exceeded $7.5 billion in trading volume. The largest protocols in this field are dYdX (starkware), Perpetual Protocol (xDAI - soon to be Arbitrum), MCDEX (Arbitrum and BSC), and of course, the Solana ecosystem: Mango Markets, Drift Protocol, and Bonfida all offer perpetual contract products.

dYdX currently dominates DEX market trading volume with over 97% of the 7-day trading volume. If you have a magnifying glass handy, you might see that the Solana ecosystem has so far captured a collective share of 0.8%. No joke, it is important to understand this chart and how quickly dYdX was able to attract a large number of users after launching its token and incentive rewards.

At the beginning of August, Perpetual Protocol was the leading protocol, accounting for 74% of daily trading volume between $100 million and $150 million. Once dYdX announced their token on August 3, the game changed. Daily DEX trading volume in August immediately more than doubled, reaching between $300 million and $500 million, with dYdX averaging 78% of trading volume in the latter half of the month when token and liquidity incentives went live in early September.

In summary, simply put, the market structure is continuously changing, and the changes are defined at the margins. So, who is growing the fastest? What catalysts might accelerate or hinder this growth?

Pulling out dYdX to better understand the potential growth of non-market leaders, we can see that the Solana ecosystem has seen significant growth over the past month. At the beginning of October, Solana accounted for about 5% of non-dYdX DEX perpetual trading volume. Fast forward to early November, and the 7-day market share has only grown by 30%. Most of the growth since late October has occurred in an environment where Solana's trading volume increased while other protocols (like Perpetual Protocol) contracted in the same timeframe.

So, while the overall Solana perpetual ecosystem is growing, which specific protocols are driving this? How is everyone growing? What catalysts and structures exist that might continue to accelerate the Solana ecosystem?

Breaking Down Solana Perpetual Protocols

Mango Markets

Mango Markets is currently the leader in the ring. It operates as a margin trading protocol, perpetual trading protocol, and money market (lending). Mango's perpetual market accounts for 93% of the total in the Solana ecosystem, providing the most market participation for traders. BTC was the first perpetual market added in late August, followed by the SOL market in September. About one-third of Mango's recent 7-day growth came from various new markets announced in early November: MNGO, ETH, SRM, RAY, ADA, and FTT.

Mango operates on an order book execution model, which can scale to offer traders various advanced order types, such as limit orders, stop-loss, take-profit, etc. Order book execution requires market makers to provide execution liquidity, so Mango offers a market-making incentive program. Taker orders incur a fee of 5 basis points, while maker orders incur no fees. Mango also does not charge fees on its lending market.

Compared to other perpetual protocols, Mango's collateral functionality is unique, stemming from the fact that Mango also serves as a margin trading and money market protocol. All of Mango's functionalities use the same collateral. Other protocols only accept stable assets like USDC as collateral, but Mango recognizes all supported borrowing assets, such as WBTC, ETH, MNGO, COPE, etc., as collateral for its perpetual market. Using volatile assets as cross-collateral for leveraged products certainly carries a higher risk curve than other protocols. Therefore, Mango has a $10 million insurance fund to protect traders until socialized losses begin. Socialized losses refer to the situation where protocol depositors bear the burden of bad debts and proportionally deduct from their balances.

Drift Protocol

Drift Protocol is a new member of the Solana perpetual ecosystem. In late October, Drift launched its closed alpha version on the mainnet, accessible by holding a Drift Alpha ticket NFT. The tickets were awarded to users who provided value to the protocol during the development phase, with only 1,500 tickets meaning fewer than 1,500 users are utilizing the mainnet protocol. Despite having gated access to SOL and only one live market, Drift has become the second-largest perpetual protocol in the Solana ecosystem, with a trading volume of $10 million in the past 7 days (accounting for 5% of Mango's 7-day trading volume).

Drift has a distinctly different execution model, leading to a creative business model. Trade execution is completed against a virtual AMM, similar to other perpetual protocols like Perpetual Protocol, MCDEX, and Futureswap. All "virtual" means that the AMM price curve is used for price discovery but does not actually hold the underlying asset—the collateral of the trader serves as the settlement source. Drift has designed a unique vAMM that combines concentrated liquidity with mechanisms for rebalancing concentrated liquidity. Without delving into technical details, it can be said that this trade execution model is primarily designed to scale the protocol without needing market-making incentives.

An interesting aspect of the vAMM execution engine is the protocol's ability to capture value during slippage. When traders define slippage tolerance for trades that exceed the slippage offered on the vAMM price curve, the protocol can capture additional slippage tolerance as a source of revenue. Co-founder Cindy Leow refers to this as "extractable value for market makers," as this business model draws inspiration from the more common MEV (miner extractable value) seen on live AMMs. Beyond this revenue source, the protocol also charges a fee of 1bps (0.01) in addition to liquidation fees.

Drift plans to open the alpha version of the protocol to all users later in the fourth quarter and add additional trading markets, as it currently only offers a single SOL-USDC market. Clearly, opening Drift to more users and larger deposits will serve as a catalyst for further accelerating Solana's perpetual trading volume. Speaking of catalysts, the protocol has yet to launch a token. By design, the token event has the potential to attract a large number of users to the platform (dYdX being the most successful case).

Bonfida

Bonfida is the third and smallest protocol offering perpetual contracts. Although it was the first to offer perpetual contracts on Solana, it has significantly lagged behind Mango with only $5 million in trading volume across its three live markets in the past 7 days. It uses vAMM for trade execution and only offers simple order types. Since much of the project's attention is focused on Bonfida's other business lines, such as its naming service, messaging, etc., it is hard to foresee any significant catalysts that would lead this protocol to surpass Mango or Drift in perpetual trading volume.

Market Structure

With an understanding of the micro-level of protocols and the catalysts for each, let’s break down the current perpetual market structure of Solana compared to other markets to understand user preferences and potential strongholds in the ecosystem.

Perpetual traders in the Solana ecosystem are distinctly different from traders on CEX and other DEXs. The BTC and ETH markets account for the vast majority of trading volume on dYdX, MCDEX, and CEX, while Solana traders (perhaps unsurprisingly) prefer to trade SOL. A bit speculative, but this suggests that the trading community on Solana is local and more enthusiastic about the Solana ecosystem, rather than traders migrating from existing platforms to trade on Solana's cheaper trading network.

Having a user base closely tied to the ecosystem is far more advantageous than mercenary users seeking the lowest-cost alternatives. From a business and competitive standpoint, this allows Solana's perpetual protocols to capture significant trading volume shares in Solana-native markets (such as Solana DeFi tokens). In fact, we can already see this happening.

Looking back at the first chart, the volume of the Solana ecosystem is nearly invisible compared to dYdX, and we now see a different, more nuanced landscape emerging. Solana DEX has captured 16% of all perpetual SOL market trading volume across all DEXs (including dYdX) in the past few weeks and 100% of the perpetual contract trading volume for Solana DeFi tokens. Most of this is driven by Mango, as it is the only DEX with perpetual markets for Solana DeFi tokens.

Thus, while the total perpetual market controlled by Solana is less than 1%, it holds a significant market share in the markets that matter most to its users. If the Solana ecosystem continues to expand, this will be a dangerous secret to success. Solana DEX is likely to be the first protocol to launch markets for Solana ecosystem tokens, continuing to attract funds from a tightly-knit user base. This seed quantity and liquidity growth, at this point, makes these protocols powerful competitors and preferred protocols in certain markets. A flywheel effect has already appeared in the relative growth data.

In an environment where other top perpetual DEXs are experiencing significant weekly trading volume contractions, the Solana ecosystem is the only one seeing an increase in trading volume. Part of the reason is the sustained interest in Mango's new Solana DeFi markets (MNGO, SRM, RAY, COPE). However, most of the growth comes from accelerated interest in the existing SOL market, which grew by 56% compared to the previous week. In contrast, other markets like ETH and BTC also saw positive growth compared to the weekly negative growth of dYdX, MCDEX, and Perpetual Protocol.

The 7-day growth is a small sample, but the Solana ecosystem has the fastest-growing decentralized perpetual protocols. This raises the question; how much of this growth is implied in the valuation of Solana ecosystem tokens?

Valuation Comparison

Quite a bit. The MNGO token accounts for 93% of trading volume in the Solana ecosystem, and its current trading volume is double its 7-day trading volume ($426 million CMC and $206 million weekly trading volume). However, dYdX's trading price is 0.06 times its 7-day trading volume, which is clearly the lowest valuation multiple in the industry. This means that Mango's trading valuation is 37 times higher than dYdX's trading volume (which is directly related to trading protocol revenue).

Now, it is not entirely fair to isolate Mango's perpetual market from the protocol's other operations. We can assume that over time, Mango's perpetual market will cannibalize its margin trading business. This is a considerable operation, about 50% larger than Mango's perpetual trading volume. As for the money market operations, the assumption of reduced margin trading leads to decreased utilization, and since Mango does not charge lending fees, we can deduct this portion from the valuation.

Thus, combining Mango's margin trading volume and perpetual trading volume, CMC's valuation for 7-day trading volume is 0.9 times. This is still about 15 times higher than dYdX and 4 times higher than MCDEX's circulating valuation.

In summary, while the Solana perpetual ecosystem is the fastest-growing in the industry, the current state of token valuation assumptions carries significant growth potential.

Conclusion

Solana has a variety of catalysts and narratives across different sectors, becoming one of the destinations for traders, and it has achieved some success as we initially observed. Overall metrics and trading volume are far behind industry leader dYdX, but the foundation composed of a consistently emotionally invested user base in the ecosystem is reassuring. Not to mention, one of the most anticipated protocols in the field—Drift Protocol—has yet to open mainnet access to all users in Solana's user base. This is a continuously growing user base—especially with major catalysts like the Brave browser bringing its 42 million active users to Solana. It will be worth keeping an eye on the growth of the ecosystem in the coming weeks to track how Solana perpetual DEX keeps pace with recent growth.