Existing DeFi insurance products support relatively single insurance standards, making it difficult to achieve effective risk hedging. Divergence’s “customized” option products provide a new option for risk hedging.
Written by: Groot
The historical collapse of the cryptocurrency market on May 19 brought huge sums of funds from centralized exchanges to the explosion and completely ignited the market’s discussion about the end of the bull market. At the same time, it also allowed me to immerse myself in the joy of the bull market for the past year. The DeFi market has experienced a “baptism of blood”. The same considerable amount of liquidation has once reached the extreme of congestion on the chain. Behind the sky-high gas price is the helplessness of market participants “nowhere to hide” when market risks erupt.
After all, for the DeFi market, although the current types of Lego components in the ecosystem are quite considerable, but for the assets on the chain, especially the LP tokens used by market participants for liquid mining and the native tokens for mining rewards, The problem of how to effectively hedge the risk of price fluctuations has not been effectively resolved. The existing DeFi insurance products support relatively single insured targets, making it difficult to achieve effective risk hedging. The Divergence introduced in this article aims to use highly customized Option products carry out risk hedging to solve this problem.
What is Divergence?
Divergence is a decentralized volatility derivatives platform that aims to provide a simple solution for users to hedge their DeFi asset’s original volatility risk exposure. In addition, it also provides a way for liquidity providers to obtain volatility premium income, which can be used as a source of additional income in addition to liquidity mining income from other agreements.
The first product is a binary options market based on AMM, with the underlying asset prices, interest rates and even pledge income, etc. covered. At present, among the main options products, the liquidity is concentrated on centralized exchanges, and mainstream assets such as BTC or ETH are basically used as trading varieties, and mainstream assets such as BTC or ETH are used for trading. The trading varieties of Divergence’s binary options products are user-specified DeFi trading pairs. The funds used to provide liquidity and trading are also DeFi assets, and can even be the second or even third-tier assets in the DeFi ecosystem, which effectively improves the options of options products. Composability.
Simply put, Divergence supports the use of almost all homogenized tokens to create an option product, such as the interest rate of mainstream lending products such as Aave and Compound, pledge rewards for different PoS assets, and various anchored assets on the chain. Decentralized stablecoins, etc., can all become the subject of option products. In addition, users can also independently set the exercise price and expiration time, and since the agreement does not require the collateral and options to be the same, they can also use stablecoins or other assets to create exotic options.
Divergence solves the market continuity problem through the automatic extension of the liquidity fund pool, thereby reducing the cost of liquidity providers to manage expiration issues in the smart contract environment, while also ensuring the continuity of its own liquidity. This also means that such products can achieve continuous market price discovery and provide the possibility for the launch of volatility indexes and index derivatives in the future.
In addition, for liquidity providers with small capital scales, maintaining option positions with different exercise prices and expiration dates in exchanges in a centralized order book environment will inevitably lead to a major discount in capital utilization. Liquidity providers can directly use LP tokens to participate in market making, and only need to provide one token asset in a pool to complete the casting of binary options, liquidity supply and trading, and the sale and purchase of option tokens. The need for over-collateralization has effectively improved the overall capital utilization efficiency of the system.
Why did you choose Binary Options?
At the agreement level, Divergence focuses on building the inclusiveness of derivatives to take full advantage of the volatility of the ever-expanding decentralized financial sector. Considering that the current DeFi market participants are exposed to various financial risk exposures, it is a rigid demand for the market to use dynamically generated derivatives to realize risk hedging, and binary options can become a sufficiently ideal “problem solution”.
Unlike futures products, options provide a non-linear risk-reward structure, enabling option buyers to construct leveraged positions of assets at a lower cost than direct trading. It is possible to construct a binary option portfolio consisting of the volatility risk exposure of different DeFi assets, and many of these options are currently unable to be found in the option market of centralized exchanges. In addition, binary options have an ideal pricing mechanism that allows buyers and sellers to exchange a predetermined number of tokens when the option expires. In the Divergence pool, if the exercise price of the binary option token is met when it expires, a collateral can be obtained, otherwise the return is zero. The prices of binary call options and binary put options are quoted and traded in units of collateral, and the sum of the two always remains as a collateral. This pricing mechanism is much easier for retail investors to understand than traditional standard options. For example, the maximum return of a call or put option purchased with 0.5 collateral is one collateral, or 2 times the principal.
In general, Divergence aims to enhance the composability, continuity and capital efficiency of the on-chain option market, and encourages the further adoption of various DeFi protocols by establishing financial risk management and income enhancement layers for other DeFi protocols.
How to realize the binary options market based on AMM?
While depositing a certain amount of collateral, the liquidity provider has minted the same amount of bullish and bearish binary options tokens and injected them into the capital pool, while the liquidity pool creator is making the market You can define the initial pricing, exercise price and expiration period of call and put options. Subsequently, as the price of call and put options deviates from the initial pricing, once more liquidity is injected, the smart contract will calculate the number of binary options tokens that can be minted based on the proportion of pledges that belong to the call and put options at that time.
When a trader deposits collateral in the liquidity pool to buy a call option, the collateral he added will be allocated to the call option side. According to the product formula of the call option side, traders will be able to purchase call option tokens at the updated price. At this time, the put option price will be updated to 1 minus the new call option price, and then the collateral and product formula for put options will be updated accordingly. At the same time, the smart contract will also calculate the amount of collateral surplus added to the liquidity pool.
In addition, Divergence has also optimized the problem of maintaining liquidity continuity for most derivative tokens with time parameters. Expired options do not need to create new contracts. An option market will always use the same contract, and every expiry date It is the state of a “round” and smart contract. As the option continues to extend after its expiration, liquidity will remain in the pool until it is withdrawn.
Before the option expires, the liquidity provider can withdraw its liquidity share under the condition that the maximum claim for the collateral of the sold option is met and the early withdrawal fee has been paid. At the same time, a certain amount of option tokens will be According to the proportion of its extracted liquidity, it was burned. Since liquidity reserves are provided to meet the maximum possible claims for options, even if all liquidity providers withdraw liquidity before expiration, the smart contract system will still retain liquidity to ensure normal transactions for users.
Development road map
In addition to launching AMM-based binary options products, Divergence will also implement the integration of Ethereum Layer 2 in the future, and will develop a smart quotation algorithm called “SPQA” to adjust for real-time volatility changes to help provide liquidity The quotation is dynamically updated according to changes in market conditions. In addition, Divergence also plans to provide LP with “portfolio margin” and increase leverage for the smart contract system to further increase the possibility of DeFi participants’ capital utilization. And all of the above functions will be determined by the community through the governance module on the pace of future launch.
In the version 2.0 planned to be launched in the third quarter of this year, Divergence will also launch a volatility index and related index derivatives. Users can use this product to realize long or short tokenized volatility targets, in addition to being used for risk hedging. , This type of product may also evolve into an independent decentralized volatility market similar to the VIX index derivatives market.
Reference materials:
https://medium.com/divergence-protocol/introducing-divergence-7fb73ae8a0a4
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