Digging into Crypto, Forex and Commodity Perps on Avantis Finance

Mackenzie Patel
Mackenzie Patel
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February 20, 2024

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Digging into Crypto, Forex and Commodity Perps on Avantis Finance

February 20, 2024
DeFi

Derivatives have always been a hot product in DeFi. From futures and options to perpetual swaps and synthetics, the rails of blockchain have been particularly conducive for self-custodied and self-determined finance. The latest iteration of this family of financial products is Avantis, a decentralized platform for trading and market-making on crypto, forex and commodities. They’re combining aspects of degen with highbrow finance, all underpinned by the almighty stablecoin, USDC.

Ever since mainnet beta launched on Feb 2 (on BASE network), users can trade perps on more than 22 assets ranging from BTC to real-world gold and silver. If you’re already 😵‍💫 with all this perp talk, here’s a quick primer:

What are Perpetuals?

Perpetuals (aka perps) are a type of derivative that allow users to speculate on the price of an underlying asset for an unlimited period of time. Users can make bets that prices will go up (long position) or down (short position) and can magnify the size of their position through leverage (leverage = borrowed funds). For example, if you think the price of Ethereum will increase, you can open a long position with $10 of capital and 3x leverage (so the total position is $30). If the price increases, you can close the position and take home the profits (current price - price at time of opening position) minus any trading or platform fees. Conversely, if the price of Ethereum goes down, you’re at risk of liquidating your position if you don’t add more collateral.

Why should I trade perpetuals?

Perps allow sophisticated traders to make bets on what direction they think the market will go. With the correct information and trading thesis, traders can make outsized profits (but as always, don’t commit more capital than you’re willing to lose).

Enter Avantis

Avantis combines the powerful features of a perp DEX with an intuitive user interface that distills the complicated nature of derivatives. It’s simple to open a position in crypto, forex (i.e. Euro / USD, USD / YEN), or commodities like gold and silver. To open a position, the user does the following:

  • Select which market you want to trade in (crypto, forex, commodities)
  • Decide if your position is long or short (aka what direction do you think the asset will go?)
  • Select the order type:
    • Market price: order placed at the current market price
    • Limit: order placed at a predetermined price
  • Deposit USDC collateral
  • Select the leverage size (up to 25x on crypto, 75x on forex, and 30x on commodities) → this magnifies this position. Leverage comes from the USDC that’s deposited into the protocol from liquidity providers (LPs)
  • Decide if you’d like to set a stop loss or take profit amount
    • This means your trade will automatically execute if certain profit or loss targets (expressed as percentages of the total position size) are hit
  • Review the opening fees and execution prices
    • Avantis has a great overview of their fee structure here. For crypto, fees are deducted upon opening a position and closing a trade, in addition to dynamic spreads and margin fees

Even though Avantis is a posterchild for slick DeFi, there are still remnants of legacy tradfi baked into the protocol because of the available assets. If users want to trade forex or commodities, they have to trade within “open” market hours (from Sunday 5 pm ET to Friday 5 pm ET - looks like we won’t be trading on Saturday!). Crypto markets are, of course, open 24/7.

Other Avantis Features

At any given time, a user can evaluate their gross p&l, or how much money they stand to earn/lose if they were to exit the position. Similar to other lending and borrowing protocols, Avantis also calculates a “health factor” score on the posted collateral. If the “maintenance collateral” isn’t sustained (i.e. falls below 15%), the position is liquidated by a bot.

One of our favorite features is the newsfeed that comes embedded into the UI, just to the right of the neon & tomato-red pricing line. Users can digest the latest news at a glance and use that to inform their trading decisions (or buy the new Solana phone, like we just did).

The Role of the LPs
Liquidity Providers (LPs) are actors who deposit USDC into Avantis to provide liquidity to traders and earn fees for putting up their capital. There are two different tranches that LPs can deposit USDC into:

  • Junior tranche - riskier but higher yield (higher exposure to fees and trader p&l)
  • Senior tranche - less risk but lower yield (lower exposure to fees and trader p&l)

Since the protocol is so new, the APYs are fantastical: the highest projected yield for the junior tranche is 89.58%! By depositing USDC, LPs are providing the leverage that traders need to amplify their positions. In exchange for their capital, LPs earn APY through trading fees and trader losses (when traders win, the profit is taken from the USDC pool).

Depositing USDC into the protocol is simple: head to earn → pick the junior or senior tranche → choose your deposit amount → approve. When the deposit is complete, LPs get a new token in return (jvUSDC or svUSDC, depending on what tranche was selected). From there, LPs can take it a step further and lock their jvUSDC or svUSDC for up to 6 months. This creates additional rewards (“rewards boost”) for the LPs and an NFT that represents the locked position (similar to the veVELO locks we wrote about last year).

Overall, Avantis is a beginner-friendly platform for trading perpetuals. Besides the UI being approachable and clear, there are several safeguards for users including the stop losses and leverage limits. It’s also apparent if your position is in the green or losing money, and these metrics are placed right next to the liquidation price. Avantis has also been audited by Zellic and Zokyo, two well-respected auditors in the crypto space.

Accounting & Tax Implications of Trading Perps

This wouldn’t be a Hash Basis article without mentioning journal entries or tax implications! Perpetuals are definitely on the gnarlier side when it comes to the books - there’s collateral, ever-changing p&l values (unrealized gain/loss) and the LP deposit/lock dynamic. For this section, we’ll cover the token flows when a perpetual position is entered into and closed (we couldn’t test out the LP section since the max vault capacity has already been reached).

Back to US GAAP Basics

A perpetual is a type of futures derivative contract that has no expiration date. GAAP has an illustrious section on how to account for these types of contracts, ASC 815, Derivatives and Hedging. In order to qualify for derivative accounting, the contract must have all of the following characteristics:

  1. Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:
    1. One or more underlyings
    2. One or more notional amounts or payment provisions or both.
  2. Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
  3. Net settlement. The contract can be settled net by any of the following means:
    1. Its terms implicitly or explicitly require or permit net settlement.
    2. It can readily be settled net by means outside the contract.
    3. It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Flipping back to the perpetuals on Avantis, we can come to the following conclusions (note: the FASB has not issued any clear guidance on this, so this is our opinion):

  1. The underlying is the price of crypto, forex or commodity.
    1. Notional is the size of the position (based on amount of USDC collateral deposited and leverage selected)
  2. While users have to deposit collateral, the amount is smaller than the overall contract size since leverage can be used (up to 75x for forex)
  3. The perps can be net settled via USDC (i.e. users don’t have to exchange the underlyings to close the position)

Therefore, the perpetuals entered into on Avantis could qualify as derivatives and be subject to derivative accounting. This means the contract sits as an asset or liability on the balance sheet, with changes in fair value flowing through the income statement at each reporting period. For businesses following GAAP, the example journal entries are:

Opening the position on Avantis by posting collateral (example)

Debit Derivative Asset $10
Credit Stablecoins $10
Debit Opening Fees $1.5
Credit Derivative Asset $1.5

Recognizing the change in fair value at period end

* assuming the fair value has increased by $2.40

Debit Derivative Asset $2.40
Credit Unrealized gain/loss on derivative $2.40

Closing the position (example)

* assuming fair value has decreased to $7.28

Debit Unrealized gain/loss on derivative $3.62
Credit Derivative asset $3.62

Debit Stablecoins $7.28
Credit Derivative asset $7.28

Debit Realized gain/loss on derivative $1.22
Credit Unrealized gain/loss on derivative $1.22

Perp Taxes 101

Similar to the FASB tale, the IRS has not issued any formal code on how to account for derivatives like perpetuals. The IRS does have guidance on Section 1256 contracts, which gives preferential tax treatment to certain derivative contracts (i.e. 60% of the overall gain/loss is considered long-term while 40% is considered short-term). However, these contracts have to be regulated by a “qualified board of exchange” such as the Commodity Futures Trading Commission (CFTC), which the perps on Avantis unfortunately are not.

For most casual investors then, the tax treatment is less complex but more costly since there are no special 1256 provisions. When positions are entered into (i.e. collateral is posted), there is no taxable event. Collateral leaves your wallet to enter the Avantis smart contracts, but you can treat this similar to entering into a staking pool (i.e. it’s a balance sheet transfer with no related gain or loss). 

When the position is closed/settled, the initial collateral is taken out of our makeshift “pool” and the difference between the initial collateral payment and settlement amount received is a capital gain or loss. If your position is liquidated, any lost collateral is treated as a disposition with an associated capital gain or loss. It’s easiest to understand by looking at an example:

       (1) A user posts 10 USDC as collateral into Avantis

       (2) User closes the trade and receives 12.536062 USDC back

In this case, the user would calculate the capital gain as 12.536062 - 10 = 2.536062 USDC. The gain would either be short-term or long-term (depending on how long the position was maintained) and reported on Schedule D / Form 8949. It’s worth noting that these perp positions are rarely long-term since keeping them open for >12 is risky and at high risk for liquidation due to price changes. Also if the user qualifies as a trader under the IRS, the tax treatment would slightly differ and the 475(f) election may apply (section 475(f) applies to securities so applying it to crypto is a gray area). For more info on trader status, read this article by Cointracker.

And there you have it on perps! They are definitely on the frontier of crypto finance and can be a game-changing product for savvy users. Avantis lowers the risk by making positions transparent and limiting losses through their stop loss functionality (which saved us a few dollars when testing out the platform!).

More info on Avantis here:

Coindesk

CryptoDaily

Avantis Twitter

Mackenzie Patel

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