white paper by the paradigm protocol foundation · 2018-04-15 · long term, paradigm is working to...

White Paper

By The Paradigm Protocol Foundation

Paradigm White Paper www.paradigmfoundation.io

Contents

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Introduction

Protocol

Usage

Options Deal Creation

Contract Fill/Exchange

Contract Settlement

Use Case

Naked Options

Looking Ahead

Approach to Performance

Exchange

Summary

IntentionFunctionality

Supported Instruments

Intention

Options

How the System Works


Introduction

With the emergence and acknowledgment of cryptocurrencies as a viable asset class, the

necessity for an effective and fitting derivatives exchange in the marketplace is evident.

Traditional Wall Street exchanges have signaled a budding interest in the space and have,

in some cases, created and offer financial products for the cryptocurrency market. While this

step signals the maturation of the cryptocurrency marketplace, it also signals a departure

from the ideology and technology that has built and been core to the cryptocurrency industry.

Blockchain technology has always been billed as a technology that will shake up the finance

and banking industry, not one that will become part of it, but the influx of institutional and more

traditional investors challenges such beliefs. These solutions seem poised to retrofit technology

and practices designed for a very different marketplace to that of the cryptocurrency market

place. These centralized derivatives exchanges are primarily plagued by the same problems

of downtime, the lack of liquidity, security flaws, and high costs. Blockchain technology has

the ability to address these issues by allowing traders to achieve higher market liquidity,

cryptographically secure exchanges, increased transparency and trust, and impactful cost

savings.

The Paradigm Project, developed by The Paradigm Protocol Foundation, is working to leverage

such benefits into a vertically integrated decentralized derivatives exchange protocol. The

Paradigm Project consists of two components: an open source protocol and an unmatched

exchange application and user experience. With this decentralized approach, we plan to

revolutionize the traditional trading paradigm. For The Paradigm Foundation, decentralized

derivatives is only the first piece of the puzzle. Long term, Paradigm is working to create a truly

free and fair, peer-to-peer market system built on the Ethereum blockchain. This white paper

will explore the components of our decentralized derivatives platform in depth and explain the

complex opportunity space in which they will operate. In addition, this white paper will discuss

future plans, upgrades and strategies that will support our long term vision of creating a truly

free and fair market system.


Protocol

Intention

Our intention for the Paradigm protocol is to create an open source and adaptable framework

for the creation, exchange and settlement of ERC20 financial contracts. Our protocol is currently

built entirely on the Ethereum blockchain, and is designed to upgrade as blockchain scaling

solutions such as Plasma, Sharding and Casper (proof-of-stake), and secondary layer solutions

become more widely adopted and developed (see more about upgrades in our approach to

performance section). The protocol process is decentralized from beginning to end, using off-

chain services only to better the user experience. This approach is key to our long term vision

of a truly democratized and decentralized market system.

At a high level, Paradigm is a completely decentralized exchange (DEX) protocol for ERC20

tokens built on Ethereum. Nested within this protocol, is a system that allows and incentivizes

developers to add logic and effectively create custom derivative contracts by simply creating

rules of value transfer. These contracts can be for things as basic as covered options (which

are being developed by our team) or potentially as complex as loan systems. In order to

increase the accessibility and leverage the power of such a system, we are also developing

the first exchange application built on the Paradigm protocol.

How the System Works

At its core, Paradigm provides access to a primary smart contract through an application

programming interface (API) and a standard interface in order to allow for an endless variety

of ERC20 token exchanges to be created. The contract, through which all exchange occurs, is

referred to as the DealController. The following page contains a technical sample of the smart

contract:


The DealController handles input from external users or systems. The arguments correspond to

several important things: the address of a deal contract to be used, the addresses for the two

tokens to be traded, numbers which are used to construct conversion & premium rates, and

the moment that the deal expires.

Each function in the DealController will fundamentally do three things:

1. Execute a function on a DealModel contract (the address of which is provided in the

arguments).

2. Process a fee to the DealModel contract benefactor.

3. Broadcast a relevant event.

DealControllers works with DealModel contracts which can be created by anyone. The only

requirements are that custom DealModel contracts stake some predetermined amount of

tokens, in order to prevent network spam, and implements the required interface:


For example, here is a skeleton of an implementation of a simple token swap:

If this contract were fully developed and deployed to the address:

Referring to the DealController code, the DealController will initialize an abstract DealModel

contract using the provided address, and it will call the relevant functions on the specific deal

contract in the execution context, in this case SimpleTokenSwap.create().

This is powerful as it allows anyone to develop their own custom DealModel contract and have

it work within the Paradigm system. The only requirement is that they adhere to the specified

interface required by the DealController.

There are several clear benefits to this model:

First, the DealController allows for a single point of entry for exchanges. Many different financial

instruments can be utilized by an exchange, and only one contract address needs to be

engaged with directly. This simplifies concerns for the exchange as there is only one API that

they need to understand.


Second, there is a single, structured event feed that consuming services (primarily exchanges)

can listen and subscribe to. This is useful both for exchanges who want to let their users know

about new available deals as well as anyone looking to perform data analysis and reporting.

This represents a critical difference between this project and other decentralized exchange

projects like 0x. Instead of relying on relayers who may or may not have all of the information

about available deals, every event subscriber gets 100% of the information about deals being

added and updated on the network.

Finally, the DealModel contract can specify a benefactor that will be awarded the transaction

fees. This incentivizes developers and companies to create new and better financial instruments

to be used by exchanges.

Supported Instruments

Options

The end goal for the Paradigm Project, is to support the richest set of derivatives on the market.

Of these, options will be at the core of the initial release, and developed by the Paradigm

Foundation.

Options are a common form of financial derivative. An option is a contract, or a provision of a

contract, that gives one party (the option holder) the right, but not the obligation to perform

a specified transaction with another party (the option issuer or option writer) according to

specified terms. [1]

There exists multiple types of options:

Call options provide the holder the right, but not the obligation, to purchase an underlying

asset at a specified price (the strike price), for a certain period of time. If the ERC20 token fails

to meet the strike price before the expiration date, the option expires and becomes worthless.

Investors buy call options when they think the price of the underlying ERC20 token will rise or sell

them if they think it will fall. Selling an option is also referred to as ‘’writing’’ an option. [2]

Put options give the holder the right to sell an underlying asset at a specified price (the strike

price). The seller (or writer) of the put option is obligated to buy the ERC20 token at the strike


price. Investors buy put options if they think the price of the underlying ERC20 token will fall, or

sell one if they think it will rise. Put buyers - those who hold a “long” - put are either speculative

buyers looking for leverage or “insurance” buyers who want to protect their long positions in an

ERC20 token for the period of time covered by the option. Put sellers hold a “short” expecting

the market to move upward (or at least stay stable). A worst-case scenario for a put seller is

a downward market turn. The maximum profit is limited to the put premium received and is

achieved when the price of the underlier is at or above the option’s strike price at expiration.

The maximum loss is unlimited for an uncovered put writer, but limited to the underlying ERC20

token for a covered option. [3]

Covered options simply mean that the seller or writer of the option owns the corresponding

amount of the underlying instrument, in our case some amount of ERC20 token. [4]

American options are options that can be exercised anytime during their life. American options

allow option holders to exercise the option at any time prior to and including its maturity date,

thus increasing the value of the option to the holder relative to European options, which can

only be exercised at maturity. The majority of exchange-traded options are American. [5]

European options are options that can only be exercised at the end of their life, at their maturity.

European options tend to sometimes trade at a discount to their comparable American option

counterpart as American options provide investors with more opportunities to exercise the

contract. European options normally trade over the counter, while American options usually

trade on standardized exchanges. [6]

The Paradigm Project will first support covered American and European call and put options

with plans to support more complex financial derivatives in the future. Such plans are detailed

later in this paper.


Usage

Our protocol consists of three primary elements: deal creation, deal participation/exchange,

and contract settlement (this can be automatic for simple instruments). These elements will

be discussed in the following sections.


Options Deal Creation (Steps 1 & 2)

A user of our protocol and options contracts can create, or “write” a deal from both the buy and

sell side. By issuing a contract order or offer (done through the DealController smart contract),

our protocol essentially creates an option with one party missing. This acts as both an order

and the framework of the option to which the other party will be added. This in not a separate

instance of contract architecture, but instead it is internal to the DealController smart contract,

with execution details specified by the DealModel contract referenced.

In the case of the sell side being the contract “writer,” the sell party specifies (see the contract

code on page 5 for the exact arguments list):

• Option type (DealModel via _dealAddress)

• Base token

• Quantity of the base token

• Expiration date

• Premium token

• Premium token quantity (this determines the strike price)

These specifications are passed as arguments into the DealController smart contract and the

sell side gives approval/allowance for the correct number of ERC20 tokens to cover the base

tokens for the deal, effectively funding the order.

The protocol then turns this into a contract and order within the DealController smart contract.

In the case of the buy side being the contract “writer”, the buy party specifies:

• Option type (DealModel via _dealAddress)

• Base token

• Quantity of base token

• Expiration date

• Premium token

• Premium token quantity (the premium determines the contract strike price)


The buy party specifies such arguments into the parameters of the DealController smart

contract function and again specifies a DealModel. Once the user gives the DealController

approval/allowance for the correct number of ERC20 tokens to cover the premium for the deal,

the deal is effectively funded.

The specified order/contract details of such steps are:

• The address of the writer

• The kind and amount of base token/premium the writer is offering

• The kind and amount of premium/base token required to fill the order

• The expiration date

Allowance must be given for the correct quantity of either the base token or premium token.

The parameters that are left undefined and mutable are:

• The address of the taker

• Allowance of the correct quantity of either the base token or premium token

This approach provides a cheap, efficient and completely decentralized system of contract

writing. This system also provides a robust and open source framework that allows any arbitrary

party to build order systems to provide wider market liquidity.


After the creation and successful funding of these options contracts, the DealController smart

contract broadcast a DealAdded event that any arbitrary party can listen to. They can listen to

such events by following the guidelines provided through our API documentation. An arbitrary

party can then build an exchange/order booking service to provide a glimpse of the market

liquidity and orders so that clients can successfully match orders. The Paradigm Exchange will

be the first such exchange. A user on the buy side of this system can discover an order they

want to purchase/engage with and then give allowance to the DealController smart contract

for their part of the deal (whether it be a premium or base token) and then execute the deal.

Executing the deal entails adding both parties and funding both sides of the deal. This then

creates the immutable, but ownership amendable deal as part of the Paradigm DealController

smart contract on the Ethereum blockchain.

Ownership amenable means that already issued contracts can be traded with this system

as well. If a party decides they want to sell their part of the contract, they can effectively

broadcast a DealAdded event for the same contract but with their side (address) open.

If someone discovers a contract they want to buy they can undertake a similar process as

above giving allowance to the DealController smart contract for their part of the deal (whether

it be a premium or base token) and then executing the deal, which entails adding both parties

and funding the contract. In the case where the contract is not filled, the original contract

remains effective.

This approach provides a completely decentralized way to provide order booking and

matching, as well as contract exchange, which is instrumental to our design philosophy. This

results in higher market liquidity, cryptographically secure exchanges, increased transparency

and trust, impactful cost savings for traders, optimized trading execution, and the most diverse

instrument offering ever.

Contract Fill/Exchange


After the deal is executed, meaning that both parties are added and the contract has been

successfully funded and executed, the deal becomes immutable (but again ownership

amendable), and the DealModel contract logic takes over.

The DealController smart contract holds the funds in escrow until the status of the options

contract changes. A status change is ordered by the specified DealModel function, and its

corresponding functions. This status change might be the exercise or expiration of the contract,

but the DealModel structure allows for operations infinitely more complex. Regardless, the

fund return function in the DealController smart contract is similar in all cases and the funds/

tokens are released to the correct wallet address, again as specified by the specific DealModel

contract.

The DealModel smart contract contains option specific execution details. Currently the

Paradigm option logic supports long/short buys and calls. Developers, as mentioned before,

can create new DealModels and demand a fee for the usage of such contracts.

(See following pages for exchange flow diagrams)

Contract Settlement


Use Case

The buy side flow for covered call option DealModels is as follows:

1. User A uses some arbitrary calculation tool to decide upon the premium they are

willing to pay for a given contract.

2. User A gives the DealController smart contract approval/allowance for the correct

number of ERC20 tokens to cover the premium for the deal.

3. User A adds the deal to the main DealController smart contract, specifying the

specific DealModel, strike price, expiration date and other contract details.

4. The DealController smart contract broadcasts a DealAdded event that any arbitrary

party can listen to.

5. User B discovers the deal and gives an allowance for all or part of the deal (some

base token).

6. User B executes the deal.

The sell side flow is similar and functions as follows:

1. User A gives the DealController smart contract approval/allowance for the correct

number of ERC20 tokens to act as the base tokens for which they would like to offer

write an option on.

2. User A adds the deal to the main DealController smart contract specifying the

specific DealModel, premium for the deal, the strike price, the expiration date and

other contract details.

3. The DealController smart contract broadcasts a DealAdded event that any arbitrary

party can listen to.

4. User B discovers the deal and gives allowance for all or part of the deal (the premium

required to purchase such a contract).

5. User B executes the deal.


Another use case of a DealModel being developed by Paradigm for the initial release, is

standard (decentralized) ERC20 spot exchange. We believe this, along with the previously

mentioned option DealModels, are so fundamental that the Paradigm Foundation has taken the

responsibility of developing these DealModels for the initial release. Standard ERC20 exchange

will be handled by the Paradigm Protocol by instituting the most fundamental DealModel.

This DealModel is constructed similar to the previously mentioned DealModels, but removes

option specific logic so the DealController contract facilitates standard decentralized ERC20

exchange. The flow of using this DealModel will work as follows:

1. User A gives the DealController smart contract approval/allowance for the ERC20 token

they want to exchange.

2. User A then adds the deal to the main DealController smart contract specifying the

DealModel, quantity, and price of the ERC20 token they want to exchange theirs for.

3. The DealController smart contract broadcasts a DealAdded event that any arbitrary party

can listen to.

4. User B discovers the deal and gives allowance for all or part of the deal (some other ERC20

token).

5. User B executes the deal and the DealController smart contract exchanges the two parties’

tokens.


Naked Options

Naked options are options where the seller of the option contract does not own any, or enough,

of the underlying security to act as protection against adverse price movements. If the price

of the underlying security moves against the trader, who does not already own the underlying

security, he or she would be required to purchase the shares regardless of how high the price

is. [7]

Generally, naked options rely on an off-chain reputation system that is factored into the pricing

of such an instrument, but Paradigm takes a different approach. The Paradigm protocol

requires all derivatives contracts to fully collateralized, thus in order to support an instrument

similar to naked options, the contract writer must utilize a lending system to collateralize their

side of the deal.

This naked option structure is similar to an off chain reputation system, as it still requires some

type of underwriting system, but makes it so that the Paradigm Protocol and DealController

smart contract can still support these types of instruments.

Paradigm is working to create a type of decentralized micro/macro peer-to-peer loan network.

We are still in the research phase of such a system, but plan to release this in later generations

of the protocol. This system will compliment and allow true decentralized naked options and

loans on the Paradigm stack.

Our protocol requires collateralization as we believe that this is the only way to accommodate

this type of instrument while maintaining our vision of a truly free and fair market system. The

fundamental inability to double spend creates a market which can’t truly exceed the monetary

supply, thus our protocol is reflective of such ideology.


Looking Ahead

The Paradigm Protocol, with its DealController/DealModel architecture, enables the creation

and exchange of truly infinite financial instruments. In order to make it as easy as possible

for developers to create such diversity, we plan to devote significant resources to creating

API documentation that is accessible,clear and expansive. The Paradigm Foundation also

plans the development of developer tutorials in order to ensure the involvement of third party

developers and exchanges with our protocol.

In regards to product offerings, the decentralized peer-to-peer loan system and underwriting

system that is being developed for naked options can easily be adapted to accommodate

short selling. To do so, party A can issue a loan to party B, specifying a token, amount and

interest rate, party B can then purchase such a loan and immediately sell the tokens, effectively

creating a short position. Then, in order to close such a position, Party B can use our standard

ERC20 exchange DealModel to repurchase the tokens and close the contract with Party A by

returning such tokens and paying the correct interest.

At Paradigm, we believe shared liquidity is fundamental to our platform and the market system

we envision. Without shared liquidity, the scope and utility of our DealController/DealModel

architecture is greatly limited. Because of this, we have initially taken the route of using

Ethereum’s built in event system for order relay. This creates a truly shared liquidity pool for

the protocol, as anyone listening to the DealController event stream hears any and all orders.

This solution, and the benefits it enables, likely make it sufficient for most retail investors, but

it lacks the performance demanded by institutional trading. We believe Ethereum’s planned

upgrades will significantly improve performance of this system, but it will still be nowhere

near the performance seen on centralized exchanges and their matching engine systems.

Because of this, Paradigm is actively working on consortium blockchain infrastructure to

handle order and crossing-related information. This consortium blockchain would essentially

function as the network transport layer of our protocol. This would allow orders to be broadcast

on a network with much higher performance while still retaining shared and decentralized

liquidity. We believe shared liquidity is so fundamental to our protocol’s architecture, that we

are working on systems that effectively require market makers on our platform to participate

in this consortium blockchain layer and share liquidity. We are approaching this challenge

from a crypto-economic viewpoint and are working to design a consortium blockchain for

orders, that incentivizes market makers to participate. This includes developing a dynamic set


Approach to Performance

Looking at the DEX landscape, there is truly only a single constant, the lack of performance. Each

and every DEX project has to, in some way, deal with the lack of performance current blockchain

technology permits. This fundamental challenge is what has kept DEXs from the mainstream,

and what for the short term will continue to do so. Regardless of the claims, no existing and

proven blockchain technology has the ability to scale to the speed and performance necessary

for the institutional traders of centralized exchanges. Every DEX project faces this problem and

will continue to face this problem until underlying blockchain technology improves. This means

that until the blockchain allows for comparable performance to that of centralized exchanges,

current DEX’s only true selling point will be that they allow users to retain custody of their funds.

This value proposition might seem important from a technological and philosophical viewpoint,

but the fact is that to general, and institutional traders, this is fairly unimportant. It is not, at least,

enough to ignore the fundamental lack of performance of DEXs.

At Paradigm, we believe there is more to leverage from a DEX protocol and exchange than

just the retention of fund custody. We believe that a completely decentralized approach to

exchange can fundamentally improve the exchange process, and we intend to become a

foundational technology for the industry, so solving the issue of performance is paramount.

We have worked to develop a platform, that due to its decentralized nature, allows things that

are impossible for centralized exchanges. This includes a platform that supports the most

diverse set of financial instruments ever, the ability to do cross pair trading, and the ability to

of rules for this consortium blockchain that will facilitate liquidity consumers rewarding liquidity

producers, by requiring payment for such market making operations. We are working hard on

this next piece of the puzzle as we believe supporting truly performant and scaled decentralized

liquidity is what will allow Paradigm to achieve the global economic impact we imagine. With

that said, we believe the technology required for the performant secondary chain and for its

interaction with the Ethereum main chain, is still in its infancy, so we are taking a proactive, yet

cautious approach to such development. We plan to deploy some version of this system later

this year and will be communicative of its research, development and progress.

In general, Paradigm plans to be proactive with developer feedback throughout the

development process and beyond, implementing upgrades and processes suggested by

developers and users.


trade completely without intermediates, all leveraged into a unmatched UI/UX experience. We

have taken a truly decentralized approach to DEXs and believe that the benefits our system

allows greatly exceed the fundamental performance tradeoff for retail traders. As blockchain

technology and performance improves, we believe these innovations will be so fundamental

to the market system, that institutional trading will transition as well. We believe we are truly

creating the exchange of the future and believe that in 5 years, when our technology has

improved to a point where it is possible to attract institutional clientele, we can become the

world’s most prominent exchange and market system.

Until then, our research team will be hard at work developing and exploring blockchain

technology that will enable highly performant systems. Our current research surrounds creating

a separate chain for order and crossing-related information. We believe this will likely be the

most effective long-term solution, we are actively working on its design and development ,

and plan a soft-launch of such system later this year. With that said, our focus remains on the

current iteration of our protocol, aimed more at retail investors. We believe the technology

required for this performant secondary chain, which will serve as the network transport layer

of our protocol, is still in its infancy, thus we are taking a proactive yet cautious approach to its

development and deployment.


Intention

Functionality

Paradigm’s approach to the decentralized order booking system creates a truly democratized

liquidity system. Each broadcasted DealAdded event can be picked up by anyone listening

to the DealController. This creates a system in which anyone can build an external exchange

that maintains the system’s entire liquidity. This system promotes a competitive marketplace

for exchanges rather than a preservationist and legacy exchange system. Paradigm plans

to release its own version of such an exchange upon release of the Paradigm protocol. Our

exchange is targeted at the experienced derivative investor, with an intuitive user experience

(UX) and user interface (UI). This UX and UI will help kick start usage of our protocol as well as

provide an experience similar, if not superior, to trading traditional securities derivatives. Our

exchange has been designed purely with the user in mind and is simple yet powerful. Our

exchange leverages the DealModel/DealController architecture by implementing a modular

design. Our exchange will also be accompanied by a rich API that will allow the creation of

exchange systems for the more niche investors and developers.

The Paradigm Exchange’s primary purpose is to display orders and streamline the protocol

process. When a party wants to trade, and uses the Paradigm Exchange to submit an order

with the Paradigm protocol, the Paradigm Exchange streamlines the entire protocol process,

simplifying the submission of an order to a single click. The Paradigm Protocol transmits a

DealAdded event broadcasting the parties’ order intent to peers and the Paradigm Exchange

displays the order intent through a web page rendering to peers. When the actual trade is

made, assets move directly from one wallet to the other via the Paradigm protocol process.

A party using the Paradigm Exchange never forfeits custody of their funds as the Paradigm

protocol is completely decentralized and therefore trustless, the exchange simply provides

a better user experience for order submission, and order book display. In order to remain

consistent with our vision of a completely free and fair market system, the Paradigm orderbook

will be open and interoperable. This will provide a complete open orderbook as events are only

broadcast at a single time, meaning order history and open orders are unseen past the current

broadcast date. This will also allow exchanges to do their own maintenance of liquidity pools.

We will provide a complete API documentation for the Paradigm Exchange upon its release.

Exchange


Exchanges will also handle order matching and execution and therefore can participate in

driving market efficiency.

In later upgrades of the Paradigm Exchange we plan to emphasize mobile friendly application

development. The Paradigm Foundation believes capturing this user base is crucial to capturing

the Paradigm Foundation’s vision.

Inevitably, there will be costs incurred maintaining order books, primarily surrounding server

use, thus external (third-party) exchanges may charge a small fee or premium. The Paradigm

Foundation’s Exchange system will be initially supported by the Paradigm Foundation Treasury,

but in the future, may switch to model in which the service is provided at-cost in order to stay

true to our vision of creating a free and fair market system.


The purpose of the Paradigm protocol is to offer a decentralized alternative to the

cryptocurrency derivatives market. Current systems in place are either centralized, or

are unadaptable. Paradigm is setting the standard by creating a truly democratized and

decentralized protocol, leveraging the opportunities of such a system, and by creating a

simple UI to create a comprehensive and meaningful user experience. Our protocol and

platform is designed to upgrade as Ethereum scaling solutions such as Casper and sharding

become active, as well as development of our own consortium blockchain progresses.

Paradigm aims to expand to other financial instruments through internal and third party

development and to eventually be the go-to protocol and exchange for anything that involves

the settlement of cryptocurrency instruments. The Paradigm Foundation’s ultimate goal is to

create a truly free and fair market system for cryptocurrencies.

Summary


[1,2,3] https://www.investopedia.com/exam-guide/cfa-level-1/derivatives/options-calls-puts.asp

[4] https://en.wikipedia.org/wiki/Covered_call

[5] https://www.investopedia.com/terms/a/americanoption.asp

[6] https://www.investopedia.com/terms/e/europeanoption.asp

[7] https://www.investopedia.com/terms/n/nakedoption.asp

Works Cited

white paper by the paradigm protocol foundation · 2018-04-15 · long term, paradigm is working to...

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