Drift Protocol: A Deep Dive Into Solana’s Hybrid Perpertual DEX

14 min readOct 5, 2024

Perpetual Market Overview

Even though decentralization is a major idea in crypto, the most popular perpetual swap contracts are on centralized exchanges. These exchanges have been accused of manipulating data, prioritizing their own profits over user fairness, and limiting user control. To address these concerns, decentralized perpetual futures exchanges are emerging, offering a more secure and transparent trading experience.

While centralized exchanges (CEXs) continue to lead the way in perpetual futures trading, the rise of decentralized perpetual protocols has been nothing short of meteoric over the past two years. These protocols have achieved a nearly 10-fold increase in their total open interest, rapidly gaining traction in a market historically dominated by centralized players.

This explosive growth has intensified competition among the numerous decentralized perpetual protocols vying for market share. The rapid expansion of trading volumes has led developers to view perpetual platforms as potentially lucrative and sustainable businesses to build, akin to the CEX model.

Many of these emerging protocols are essentially forks or iterations of the first-mover decentralized exchanges like GMX and dYdX. Innovation often focuses on relatively minor areas such as the choice of price feeds utilized, variations in trading fee structures, or different incentive mechanisms to attract and retain users.

Much like the broader decentralized exchange (DEX) landscape, each sub-sector of DeFi seems to spawn a multitude of similar forks and replicas. In the perpetual arena specifically, this proliferation of near-identical protocols intensifies the competition due to their relatively simplistic business models and revenue streams.

However, amidst this competitive environment, there exists an untapped opportunity — protocols have yet to effectively utilize the liquidity generated from perpetual trading to create innovative “DeFi Lego” building blocks and financial primitives. This could open up new avenues for differentiation and value creation beyond the perpetual use case alone.

Introducing Drift: A Hybrid Decentralized Exchange on Solana

Drift Protocol is a novel decentralized exchange built on the Solana blockchain. It facilitates perpetual swap trading, a popular crypto derivative, in a fully on-chain and decentralized manner. Notably, Drift leverages Solana’s high transaction speed (with block times of 400 milliseconds) to ensure a smooth trading experience.

The decision to build on Solana wasn’t solely speed-driven. Solana’s rich ecosystem of DeFi protocols presented an opportunity for future integration. Drift is particularly interested in incorporating lending and yield aggregation functionalities, potentially allowing users to earn interest on their unused collateral within the platform.

Finally, Drift aims to address a significant pain point for decentralized exchange users: high gas fees. Unlike Ethereum-based DEXes, where users incur gas fees for bridging funds and interacting with the platform, Drift leverages Solana’s low fees. This eliminates unnecessary costs and makes Drift a more attractive option, especially for smaller traders.

In the next section, we’ll delve into the concepts of market makers (MM) and virtual automated market makers (vAMM) used by Drift Protocol.

Types of market makers (MMs)

An Automated Market Maker (AMM) is a system that automates the process of distributing liquidity. It encourages users to become liquidity providers in exchange for a percentage of transaction costs and free tokens.
A virtual AMM (vAMM) is essentially an AMM for derivative contracts, such as perpetual swaps.The nature of a vAMM is that the more individuals who utilize it, the better it functions because there will be more people providing greater liquidity to the platform.

Drift is unique in the sense that they’ve come up with what’s called a Dynamic Virtual AMM or dAMM.

Dynamic Virtual Automated Market Maker (dAMM)

Drift Protocol has developed a Dynamic Virtual Automated Market Maker (dAMM) that aims to reduce slippage for traders over time while adapting to market trading demand.

The dAMM tries to fix slippage issues present in traditional vAMMs by using a portion of the fees collected to readjust the pricing curve. This helps bring the mark price (perpetual contract price) closer to the oracle price (spot market price) over time, providing traders with the best possible prices.

This figure clearly shows how the platform’s fees are used to provide traders with the best market prices. When traders open a position, they pay a 0.1% fee, which goes into the Drift Protocol’s fee pool.

(A trader with $1000 going all in with 1x leverage pays a $1 fee, whereas the same trader going all in with 5x leverage pays a $5 fee because the total position size is now $5000 due to the 5x leverage.)

A percentage of the fees collected in this fee pool is utilized to execute the three processes described above (repeat, K adjustment, and funding payments), all with the goal of ensuring that liquidity, slippage, and Drift’s mark price against its oracle price are within acceptable ranges.

A deep dive into Drift’s dAMM: Understanding the architecture

Drift Protocol’s Dynamic Automated Market Maker (dAMM) has two unique mechanisms that set it apart from traditional virtual AMMs (vAMMs) — the re-peg mechanism and the adjustable K parameter.

The Re-Peg Mechanism

This feature helps address issues where the mark price (the price of the perpetual contract) diverges too far away from the oracle price (the actual spot market price of the asset). Here’s how it works:

Imagine you enter a trade to buy the SOL cryptocurrency when it is priced at $100. Very quickly, the price skyrockets to $200 and you want to sell to lock in profits. However, when you try to exit your position at $200, you experience high slippage or poor pricing because liquidity is concentrated at the $100 level based on the pricing curve.

In a traditional vAMM, the only way to get better pricing at $200 is if there is enough trading demand from arbitrageurs to “re-peg” or shift the curve to that new price level. If not enough demand, the vAMM has to reduce the parameter K, which essentially dilutes the pricing curve around $200 but also worsens pricing for those who entered earlier around $100.

Drift’s re-peg mechanism improves this by automatically initiating a re-peg event whenever the mark price diverges too far from the oracle price (more than 10%) or if the funding rates become too high. This shifts the pricing curve to concentrate liquidity at the current market price of $200, allowing new traders to get better pricing while still allowing early entries to exit with minimal slippage.

The Adjustable K

The other key innovation is the adjustable K parameter, which represents the depth of the virtual liquidity pool in the core formula x*y=K used by AMMs.

If K is set too low compared to trading volumes, even small trades can cause high slippage as there is insufficient liquidity depth. However, if K is too high, it becomes difficult for arbitrageurs to maintain efficient pricing.

Drift’s dAMM continuously monitors trading activity. When it detects conditions causing a “K-error bias” where K is misaligned with market dynamics, it automatically adjusts the K value in increments.

If there are more longs than shorts and the oracle price is higher than the mark price, this signals K is too low, so Drift increases K to deepen liquidity.

Conversely, if there are more longs than shorts but the oracle price is lower, this means K is too high, so Drift reduces K to tighten liquidity appropriately.

By dynamically adjusting K based on evolving open interest and trading volumes, the dAMM ensures the liquidity pool stays right-sized. This allows it to provide consistently low slippage for traders rather than being too shallow or overly deep.

In essence, the re-peg mechanism concentrates liquidity at the right price levels, while the adjustable K controls the overall depth and efficiency of the liquidity pool itself. Together, these innovative mechanisms in Drift’s dAMM provide an optimized and responsive automated market-making system for perpetual contracts.

Positive Feedback Loop

Drift Protocol has ingeniously created a positive feedback loop that ties trading volumes to better pricing and liquidity for users. As more trading takes place on the platform, it generates more fees that get fed back into optimizing the dAMM mechanisms, incentivizing even higher volumes — and so the virtuous cycle continues.

Imagine you take a $1 million position in SOL on Drift. Due to the trading size, you experience some slippage and a noticeable impact on the mark price upon entry. Not ideal, but to be expected with large orders.

Now fast forward a week. More traders have started using Drift, tripling the number of active users. Total trading volumes have increased tenfold. When you enter that same $1 million SOL position, you notice significantly reduced slippage compared to before. The larger trading volumes provided more fees for Drift to apply its re-pegging and K-adjustment mechanisms, concentrating liquidity around the active price levels.

Another week goes by — user numbers have tripled again and volumes are up another 10x. You place the $1 million trade and slippage is even lower, with less impact on the mark price too. Price discovery and execution have improved even further.

This trend continues week after week as Drift’s liquidity virtuous cycle kicks in. More volumes mean more fees collected, allowing better liquidity management which attracts even higher volumes by providing superior pricing for traders. Slippage decreases, price impact is minimized.

The driving force is the fees generated from trading volumes. A portion gets allocated to facilitating frequent re-pegs to the current market price, while another portion dynamically adjusts the K parameter to set optimal liquidity depth. As volumes ramp up, these mechanisms can be applied more prolifically to create an increasingly refined and efficient dAMM liquidity environment.

In essence, the more Drift is used for trading, the better the pricing and execution will get for those trades, thanks to this positive feedback loop dynamic. Superior pricing and liquidity then incentivizes even higher usage, capturing more volume into the virtuous cycle. It’s an innovative mechanism that allows the dAMM to continuously improve itself.

Drift V1 and Its Problems

Perpetual Protocol,another perp exchange, introduced a new concept called the virtual Automated Market Maker (vAMM). Unlike traditional AMMs that use real cryptocurrencies, vAMMs operate with virtual assets. The core idea is similar, though: a mathematical formula dictates pricing, but with a predetermined and fixed amount of liquidity.

Drift Protocol’s v1 version built upon this concept with two key improvements: re-pegging and liquidity adjustment.

Re-pegging ensures trades happen in a zone with more liquidity. The system uses an oracle (a reliable source) to get the latest SOL price and adjusts the virtual asset price accordingly. This keeps trades within a zone with sufficient liquidity for better execution.

Liquidity adjustment involves using the fees collected from trades to enhance liquidity within the vAMM pool. Similar to adding more candy bars to the vending machine, Drift injects these fees back into the vAMM, effectively increasing the overall liquidity available for trading.

The Problem

Drift V1, a decentralized perpetual trading protocol, faced a significant challenge with its virtual Automated Market Maker (vAMM) implementation. Unlike traditional Automated Market Makers (AMMs) or peer-to-pool models, where there are always passive liquidity providers (LPs) from whom traders can profit, Drift V1’s vAMM operated without passive LPs. Instead, traders essentially acted as ‘LPs’ for each other, creating a player-versus-player (PVP) market. In this setup, one trader’s profit necessitated another trader’s loss, introducing asymmetric trading dynamics.

This asymmetric model carried risks. One concern was the potential for market collapse if arbitrageurs could not generate sufficient profits to sustain the system. Additionally, if not managed properly, leverage could lead to price manipulation and insolvency. A manipulator could open two high-leverage positions to push the price to a point where the profit from one position covers the loss from the other, effectively draining funds from other users.

Despite its initial success as a premier perpetual protocol, Drift V1 faced severe setbacks during the Terra Luna collapse in May 2022. According to the Drift Technical Incident Report, collateral was mischaracterized, allowing users to withdraw profits without proper checks in place, and without a socialized loss and clawback mechanism.

Before the Terra Luna incident, in April 2022, Drift ranked fifth among perpetual players with a Total Value Locked (TVL) of approximately $15.4M, trailing dYdX ($1.01B), Mirror ($743M), GMX ($530M), and Perpetual ($160M). Mirror, a derivatives protocol on Terra, no longer exists as it collapsed during the Terra Luna incident when the entire Terra ecosystem went down.

Following these challenges, Drift V1 was discontinued, and Drift V2 was introduced in December 2022. By May 1, 2023, V2 had achieved significant milestones, including 2.3M total trades, a cumulative volume of $529M, and a user base of 3,058 unique traders. While these numbers may seem less impressive compared to Drift V1’s cumulative trading volume of $7.24B by March 2022 (just a month before it was phased out), a closer look reveals a promising trend. The average volume per user for Drift V2 stands at a remarkable $169K, which speaks volumes about the product’s robustness, largely underpinned by its innovative dAMM model.

Drift v2 Core Design

Drift V2 introduces a hybrid liquidity solution to provide more collateral and lower the risk of the vAMM (virtual Automated Market Maker) itself. Drift V2 has three types of liquidity to ensure the best price for traders when an order is executed:

1. Just-in-Time (JIT) Liquidity:

When a trader submits a market order, it is broadcasted to a network of market makers (called Keepers) and initiates a Dutch auction. This auction lasts for 5 seconds, and the starting price is determined by the oracle price and the vAMM’s inventory status. During this process, market makers continuously front-run in a race, with the price changing from best to worst for the taker. JIT auction allows traders to experience zero slippage.

2. vAMM Liquidity:

In Drift V2, the vAMM acts as a backstop liquidity source if no market makers execute the market orders. The Drift V2 AMM features an in-built bid/ask spread and Drift Liquidity Providers (DLPs). DLPs are passive liquidity providers that open opposing positions against the vAMM. Users can add liquidity to specific pools and earn a share of the taker fees. The in-built bid/ask spread makes the Drift vAMM wider, providing more liquidity than just filling at the current oracle price. This process eases the long/short imbalance at a higher cost.

Drift V2 also introduces a new oracle-based pricing mechanism that optimizes the process of repegging and setting spreads by considering factors like volatility and inventory. This ensures that arbitrageurs engage in activities to balance long and short positions efficiently.

3. Decentralized Orderbook (DLOB) Liquidity:

Drift V2 provides a decentralized orderbook network. Keepers (bots) are responsible for recording, storing, matching, and filling submitted limit orders. Each Keeper bot has its own off-chain orderbook, where orders are sorted by price, age, and position size. When an order meets the trigger price, Keepers submit trades against the DAMM (Decentralized Automated Market Maker) and receive a proportion of the trading fee.

Additionally, Drift V2 offers spot trading, spot margin trading, swaps, and lending/borrowing services.

As for growth catalysts, Drift plans to launch its own points system as a member of the points-meta. Despite not having a native token until now, Drift V2 has already achieved over 5 billion in total trading volume and nearly 100,000 users. The team expects that after the launch of the points system, the Drift protocol will gain a larger market share and trading volume.

Additional characteristics

Spot

Spot trading and spot margin trading are offered by Drift V2. All forms of spot trading are grounded in actual underlying assets, as opposed to eternal trading. For example, OpenBook DEX provides the liquidity for spot trade. Furthermore, users can leverage their spot by borrowing assets on Drift V2 through spot and margin trading. Hedging the perpetual position is the primary goal of the two approaches.

Swap

Jupiter routing is used by Swap on Drift to give users the best possible price. But Drift V2 itself is the source of liquidity. With flash loans, users can leverage swaps as well.

Lend/Borrow

Similar to Aave, the drift lending module makes use of an overcollateral technique. When you give Drift your assets, the assets will generate a yield automatically.

Catalyst for Growth

In 2021, Drift released its V1. Drift hasn’t had a native token up until now, which means it’s missing out on a chance to encourage protocol user onboarding. In spite of this, Drift V2 has amassed approximately 100,000 users and a total trading volume of over $5 billion.

Drift declared on January 24, 2024, that it would join the points meta and introduce a three-month-long points system of its own. Drift is a well-resourced company with a track record of quickly iterating products. We anticipate that the Drift protocol will increase in market share and trade volume following the introduction of the points system.

dAMM vs. Traditional order-books

Here is a paraphrased and expanded explanation comparing Drift’s dAMM to traditional orderbook systems in a way that is understandable for a layperson:

Traditional exchanges, both centralized and some decentralized ones, rely on an orderbook system to facilitate trading. However, Drift Protocol’s dynamic Automated Market Maker (dAMM) offers several potential advantages over this traditional model.

The key issue with orderbooks is their reliance on external market makers to provide liquidity and pricing. This leaves orderbooks vulnerable to predatory practices like “spoofing” of orders.

Spoofing occurs when large buy or sell orders are placed on the orderbook, tricking traders into thinking there is significant demand or supply at that price level. But when the price gets close, those orders are withdrawn or canceled, effectively “spoofing” or faking out traders who tried to front-run the orders.

This is a major drawback, as liquidity shown on an orderbook is not guaranteed and can be pulled away at any moment by the market makers providing it.

In contrast, Drift’s dAMM operates with full mathematical transparency based on its pricing formulas and mechanisms. There is no reliance on external market makers that could manipulate pricing through spoofing tactics.

Instead of external liquidity providers, Drift’s liquidity comes directly from the participants trading on the platform. More specifically, it relies on arbitrageurs — traders who profit from price inefficiencies across markets.

Arbitrageurs are incentivized to maintain efficient pricing on Drift by taking the other side of trades and hedging their exposures. They earn rewards from the funding payments collected on the platform.

Drift doesn’t require a traditional 50/50 liquidity pool model. Its liquidity depths are dynamically adjusted through the dAMM’s re-pegging mechanism and adjustable K parameter as trading volumes fluctuate.

By concentrating liquidity at the right price levels through re-pegs and sizing overall liquidity appropriately via K, the dAMM provides “purer” price action based solely on market forces and underlying asset prices.

There is no potential for spoofed liquidity being pulled, as Drift generates real liquidity from its own participants rather than rent-seeking external market makers.

So while orderbooks carry the risk of manipulated liquidity and pricing from third parties, Drift’s dAMM creates an autonomous and transparent liquidity pool driven by the platform’s own traders and arbitrageurs. This allows for more reliable and efficient price discovery and trade execution.

Final Words

Over the past several weeks, I’ve had the opportunity to test Drift. With a few minor hiccups, the UX was reasonably seamless and my transactions were completed swiftly when combined with Solana’s speed. The user interface is clear and minimal costs for deposits and gas were charged.

Innovative technologies like dAMM and DLOB, quick transactions, and an intuitive user interface are all provided by Drift Protocol. By not depending on conventional market procedures, these guarantee little slippage and robust liquidity.

You can check is out here:

App.Drift.Trade

With continued work and more achievements, Drift could become the top decentralized on-chain perpetual swap exchange. This makes it a project that should be carefully watched.