The immature option market of cryptocurrency exchanges gives DeFi an opportunity to become a competitor of Deribit. Opyn or Hegic options may one day become the hottest darling of the WallStreetBets sector in Reddit.
Written by: Parsec Research, a research department under parsec.finance
Compiler: Perry Wang
parsec.finance authorized chain news to translate and publish the Chinese version of this article.
Although the cryptocurrency options market is developing slowly, Deribit finally made a breakthrough and provided the first batch of retail-friendly crypto option products. Like many cryptocurrency derivatives, these products cannot be sold in the United States and require asset custody. The fact that the crypto options market is still immature provides a huge opportunity for open finance. Not only is the structure of options complicated, but the pricing and margin requirements are also complicated. The buyer of American options only has the right to buy or sell the underlying asset at the strike price before a certain date, but has no obligation. If it can be liquidated in kind, no oracle is even needed. Like decentralized financial DeFi, the challenge of this type of product usually comes down to liquidity.
The true rise of DeFi is attributed to the collective liquidity model, the most famous being Uniswap , Compound and Synthetix . These agreements dwarf the peer-to-peer P2P model to a large extent, and this is most evident in the Dharma project’s transition from the P2P lending model to the Compound interface. These agreements all have different risks associated with their respective liquidity pools, but usually these models allow risk seekers to set it up and forget it, without actively monitoring the risks/returns associated with liquidity pool products. This allows experienced market makers to have fewer ways to generate differentiated alpha values. For example, in the Uniswap agreement, all that everyone can do is increase/eliminate liquidity. By limiting the alpha of complex participants, the agreement can accumulate “inert” capital. New Ethereum option agreement projects, especially Opyn and Hegic , have recognized the need for liquidity pooling and are establishing pooled option agreements.
Opyn
Opyn is built on the convexity protocol (a pure option protocol with some key additional functions). In a short period of time, Opyn has accumulated considerable trading volume, especially ETH put option products.
Opyn’s cumulative nominal transaction volume ($), data provided by Dune Analytics
For example, an ETH/USDC option with an exercise price of $100; in a standard option, the author will lock in collateral of $100 (conditional on 100% mortgage or underwriting) in exchange for a premium. If the option buyer exercises, they will remit 1 ETH and receive a refund of 100 USDC. Similar to the implementation of the Opyn agreement, the option writer sends 100 USDC in exchange for an exchangeable oToken . In order for the author to cash in on this premium, they need to sell this oToken on the exchange.
An important feature here is that there is no connection between the oToken and the deposited 100 USDC. The oToken is a proof of claim from the collateral pool. Therefore, option creation is equivalent to contract. In the case of a 100% mortgage, this is meaningless, but the liquidity pool architecture provides two key features in other systems.
First of all, collateral can be provided in currencies other than the quoted assets, and its clearing mechanism is similar to Compound and dYdX , anchored on top. Opyn has launched some of these markets. ocDAI launched a market that uses ETH as collateral, mainly because the yield of ETH << the yield of USDC. This is an opportunity cost reason, because by locking USDC in the market, investors will bear compound risks, and in fact do not get the considerable gains that USDC (usually) generates. With ETH mortgage, the author will give up the annual interest rate of 2 basis points and obtain a premium of approximately 1%-10%. The consideration is the over-value mortgage of non-performing asset collateral, which is currently set at 140%. Assuming a safe position will leave room for a 20% drop, the over-collateralization ratio reaches 175%. Reduced capital efficiency not only limits the seller’s liquidity, but also limits the ideal premium range for more assets.
The second benefit of merging collateral is that it provides a way to merge unsecured rights pools. I still firmly believe that the only effective way forward in DeFi for loans, underwriting, etc. is to share risks and reduce the heavy capital intensity of these products. If centralized finance CeFi and BitMEX have taught us anything, it is that leverage is king. By consolidating option collateral, Opyn opens up a feasible way to reduce capital requirements and can be secured by options without requiring 100% collateral. A specific example is ” credit spread ” transactions.
Right to put $180 put option, buy $160 put option credit spread profit and loss
When a trader enters a credit spread, it limits the gains and losses and sets a ceiling boundary. Therefore, after calculating the transaction amount, the collateral demand can be reduced to the maximum loss amount, which is $20 in the above case. In this transaction case, the net transaction will increase capital efficiency by 9 times. As the collateral is merged, users will be able to execute this atomic credit spread with a margin of $20, and at the same time, the right underwriting pool will increase zero risk.
Another way to use Opyn for unsecured rights is similar to the UMA ‘s maintenance margin model. The idea here is to value the risk exposure of the option seller and maintain the collateral at a certain multiple of that valuation, thereby creating a scenario where the current value of the position is mortgaged instead of the full exposure. For deep out-of-pocket (OTM) options, their value and risk exposure may be seriously unbalanced. Take the ETH 04/24/20 exercise price option of $100 as an example. The current transaction price is $0.90. The port is 1 ETH. In the maintenance margin system, a premium of 90 cents is a huge cost. You may need 2 times this value as a margin, and if the value increases, you need to constantly replenish the margin. Obviously, this model has huge capital efficiency gains, but it brings many very difficult problems.
First of all, the oracle machine must evaluate the option price, and it needs to predict safely both technically and mathematically. Secondly, the maintainer of the oracle must participate in the liquidation of unmargin- backed positions. The painful lesson of the MakerDAO agreement let everyone know that the maintainer will not always show up.
Once the option is established and mortgaged, the actual process of selling tokens depends on the market. Opyn’s current preferred place to obtain liquidity is Uniswap, which is easy to set up and can increase liquidity when an asset faces liquidity challenges. It is very suitable for buyers and sellers, but the liquidity provider LP is involved in quite complex products in Uniswap. Uniswap LP’s income profile is not easy to understand ( in-depth understanding ). The point is that if the general direction movement exceeds the range of the direction movement driven by the cost, it will result in a negative return. For oToken, LP must be very careful, especially in the case of out-of-pocket OTM options.
As the exercise day approaches, the time premium decreases to zero, and the OTM exercise price is usually worthless. As the price gradually drops to nearly zero, LP actually sells all ETH to buy oToken that is about to expire. For LP, this is not true. We cannot expect any actual liquidity in these markets. The probability of their appearance in the currency is close to zero. This is the same reason the automated market maker AMM does not work well in the prediction market. For Opyn, the question becomes: Does a set of AMMs across exercise/expiry bring combined trading liquidity? It is the classic order book transaction to achieve this, and the traditional option market maker plays a role. Order book routing is much easier, but may lack the proven architecture of the DeFi protocol.
Hegic
Hegic, in accordance with the true cypherpunk tradition, was created and operated by an anonymous founder named Molly. Hegic is a novel method in the on-chain option agreement. With Hegic, the creation and sale of options is done by a group of participants.
In the simplest terms, Hegic is an option contract upon request. The buyer gets a fixed-term (currently 1, 2, 4, or 8 week) option quotes. If you buy an option, the liquidity pool will lock the corresponding collateral until the contract expires or the option is exercised. By injecting capital into the liquidity pool, the LP earns a proportionally distributed option premium, and therefore accepts the risk of gaining profits from the buyer’s transaction. Therefore, Hegic brings together the underwriting of the underlying assets of collateral and the purchase/exercise of options.
For option buyers, Hegic provides an incredible user experience UX, and considering that the collateral pool is healthy, liquidity problems are alleviated. Illiquid options are usually the most interesting product. Do you think Tesla is going bankrupt? Buy $100 put option. The problem is that these products traditionally have high spreads and lack of participants willing to trade on the other end, and Hegic always stands at one end of the transaction.
For the LP, you are an option that supports the creation of rights on your collateral, which is terrible. Option creation is a very complex business, and any spot or futures hedging must be done outside of Hegic. Broadly speaking, the goal of option market makers is to establish options slightly higher than their true value, and hold as little position as possible at the bottom. Currently, Hegic cannot restrict LP’s position. Using only put options, Hegic makes LP structurally buying bullish ETH. This is acceptable to many people, but there are actually safer and more profitable ways to do long ETH. The introduction of call options will help alleviate this situation, but the long-term existence of this problem is abnormal. Imagine there are 100 contracts, 90 of which are single OTM puts, and the position of LP relative to the owner of the 90 contracts completely exceeds the remaining combined positions, making LP a pure speculator. Synthetix faced similar problems with synths’ combined liquidity. The perpetual contract financing model can solve similar problems, but the complexity of Hegic’s financing model may be an order of magnitude higher.
The obvious question is, how are options priced? The price must be competitive while protecting the interests of LP, which is a difficult task. Initially, the pricing model was simple: based on a certain percentage of the exercise price, the percentage decreased linearly with respect to the current price, and a small exercise fee was charged at the time of exercise. The final product is a constant pricing function with discrete values (strike price + contract duration) on the entire surface. The current model is compelling in terms of its simplicity, but its v2 is being upgraded to attract sophisticated LPs whose information is fully exposed.
When ETH = $200, the current Hegic price list (x = strike price)
It is worth considering what happens when Hegic misprises options. Once appropriate liquidity is obtained, arbitrage will flow out of the Derbit derivatives exchange; in most cases, due to the custom expiration and the inability to directly establish rights trading, it will not be a clean 1:1 arbitrage transaction, but it is sufficient The price difference will bring huge profit opportunities. In most arbitrage transactions, the scale is limited by places with less liquidity. For Hegic, the liquidity of any contract is the remaining capital scale of the entire liquidity pool, which will cause Hegic LP’s ETH position to be distorted as described above. The ultimate goal is to protect LPs from huge losses, making the “accuracy” of the price essential. This is the only way for Hegic to gain liquidity.
In addition, Hegic will launch a token (HEGIC). This token provides special rights to buyers and rights holders. Holders can enjoy premium discounts on Hegic contracts. Those token holders who provide liquidity to the authorized fund pool are given priority release rights. The usual way of liquidity release is: if the liquidity exceeds the number of LPs to be released, the LP can release, otherwise, they will queue and wait for the flow Sexual release. By holding HEGIC, LP can be swapped with development funds (funded by selling HEGIC) even if the free liquidity in the fund pool is insufficient. Finally, HEGIC is also a decentralized organization DAO , holding tokens can enjoy the right to vote for protocol upgrades (similar to MKR). Although in the eyes of some people, the token looks like a superfluous supplement to some extent, the reality is that the protocol upgrade will always require operation and capital, and the investment flow will come from option buyers/sellers who want to share the agreement’s upward gains. And community members.
to sum up
The options market is still quite immature in various cryptocurrency exchanges, which brings huge opportunities to DeFi, which can win a certain amount of liquidity and may become a competitor of Deribit. Maybe one day, Opyn or Hegic options will become the hottest darlings of Reddit’s WallStreetBets section.
Thank you Zubin Koticha (Opyn) and Molly (Hegic) for discussing your agreement with me.
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