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Overview

Radian allows you to create synthetic derivatives based on any value so long as it can be represented as a number in a smart contract.

At a high-level: synthetic derivatives in Radian work much like perpetual contracts commonly seen on centralized crypto exchanges where one side (e.g. longs) pays a continual funding rate to the other side (e.g. shorts) based on the long-short ratio.

However, the description above is not practical on-chain due to the fact that it would require too many on-chain transactions. Instead, Radian uses a different model where the funding rate is instead represented in the change of the price itself. Synthetic derivatives on Radian are inspired by the power perpetuals paper by Paradigm. The main difference is that Radian generalizes the concept to allow for any value to be represented as a synthetic derivative, rather than just the power of a price of an asset.

Creating Derivatives​

The heart of a synthetic derivative lies in the index price. To create a derivative, you can implement a smart contract that exposes an indexPrice function which determines the index price of the derivative. This means you can make a derivative that tracks not just prices, but anything with a numerical value, so long as it can be computed on-chain. Once you have created your index price contract, you can deploy a derivative contract using the DerivativeFactory contract, and pass in the address of your index price contract, as well as the funding rate which we will discuss next.

Funding Rate​

The funding rate determines the fee which is paid over time from longs to shorts. Unlike in perpetual contracts where the side which pays the fee can change, in Radian the funding rate is always paid from longs to shorts (with some exceptions). This means that the short side always earns a constant fee.

The funding rate is also a function that will be implemented in your contract and is therefore dynamic. This feature is a key part of the protocol as it allows previously impractical derivatives to become practical. For example, if you wanted to create a derivative that tracks the temperature of Los Angeles, a constant funding rate would not be practical because the temperature of a city is somewhat predictable, and therefore the incentive for shorts would be low in January (the coldest month in Los Angeles), and high in July (the hottest month in Los Angeles). Therefore the funding rate should be very high in January, and very low (or even negative) in July .

Another important to keep in mind when designing the funding rate is to design it such that it accounts for the volatility of the underlying index price. If the volatility is high, then the risk-adjusted return for the short side will be lower, and thus the funding rate should be higher.

To summarize, the funding rate exists purely as an economic incentive for the short side to maintain the derivative, as the short side is the side taking the most risk, and the funding rate should be proportional to the risk-adjusted return of the short side.

Minting Liquidity​

Also unlike traditional perpetual contracts, in Radian, only the short side can be liquidated. This means that the long side can never be liquidated, and thus the long side can never be forced to exit the position. Also, the short side initiates the creation of liquidity, which means that the short side must put up collateral in order to mint liquidity.

Market Price​

Since it would not be practical to have every long position pay some fee via an on-chain transaction on some time interval, Radian instead applies a normalization factor to the index price of the derivative in order to derive the market price. The market price is the price paid to buy or sell the derivative directly to the contract. This mechanic is similar to the exchange rate in lending markets such as compound, where the exchange rate of cDAI to DAI is always increasing according to the interest rate.

For example in Compound, when you supply DAI, you receive cDAI at some exchange rate, for example 1.0 cDAI per DAI. If the interest rate is 12%, then the exchange rate will increase slightly every block, so when you exchange your cDAI back to DAI a month later, the exchange rate would be, for example 1.01 cDAI per DAI. This means that you earned 1% interest on your DAI. This mechanic allows interest to be earned by the entire set of DAI lenders in the protocol by adjusting only a single number on-chain.

Similarly, the normalization factor in the derivative contract behaves the same way, but instead decreases the market price by the funding rate over time, relative to the index price.

Lifecycle of a Derivative​

In this example, we will describe the lifecycle of a derivative which tracks the temperature of a city in Farenheit. It is assumed that there exists an on-chain oracle which can provide the temperature of the city in Farenheit. We will call this derivative TEMP.

  1. Deploy the TEMP index price contract, which exposes:
  • an indexPrice function that returns a uint256 representing the temperature of the city in Farenheit (multiplied by 10^6).
  • a fundingRate function that returns a uint256 representing the current funding rate (multiplied by 10^6).
  1. Deploy the TEMP derivative contract using the DerivativeFactory contract, and pass in the address of the TEMP index price contract, which deploys the TEMPDerivative contract.
  2. The short side mints liquidity by calling the mint function on the TEMPDerivative contract, and puts up collateral in the form of USDX. The collateral is locked in the TEMPDerivative contract, and mints sTEMP (synthetic temperature) tokens to the short side.
  3. The short side sells sTEMP tokens to the long side at the market price, which is the current index price of the derivative, multiplied by the normalization factor.

Now let's look at the 3 possible future scenarios assuming a 12% average funding rate:

Scenario 1: The temperature of the city goes up 10% over the next month​

In this scenario, the index price of the derivative goes up, and the short side takes a 10% loss, minus the 1% of earnings from the funding rate, totaling a 9% loss.

Scenario 2: The temperature of the city goes down 10% over the next month​

In this scenario, the index price of the derivative goes down, and the short side takes a 10% gain, plus the 1% of earnings from the funding rate, totaling a 11% gain.

Scenario 3: The temperature of the city stays the same over the next month​

In this scenario, the index price of the derivative stays the same, and the short side takes a 0% gain, plus the 1% of earnings from the funding rate, totaling a 1% gain.

Price Pegging Mechanism​

Due to the fact that sTEMP in the example above can always be redeemed for the underlying USDX collateral at the market price, as well as minted at the market price, the market price of sTEMP on other exchanges should always be equal to the market price of sTEMP on Radian, otherwise there will be an arbitrage opportunity. For example:

Since the market price to mint is computed by the index price, this means that anyone can always mint more sTEMP at that price. So if the price of sTEMP goes above the market price, then there will be an arbitrage opportunity to mint more sTEMP and sell it at the market price.

Similarly, since sTEMP can always be redeemed for the underlying USDX collateral at the market price, if the price of sTEMP goes below the market price, then there will be an arbitrage opportunity to buy sTEMP at the market price and redeem it for USDX.

This means that the primary method via which to go long sTEMP is to simply buy it from any exchange that lists it.