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Why are DeFi options protocols generally underdeveloped?

Read this article in 26 Minutes

Starting from the source of option liquidity, decompose the logic behind the supply and demand of option products.

Original title: "A deep dive into DeFi option protocols"

Original author: Rapolas, Zee Prime Capital

Original compilation: Eva, chain catcher

If you have read anything about options before, you probably know by now that options in TradFi are seriously problematic. In fact, in the U.S., the notional value of stocks represented through daily options exchanges has surpassed spot values for the first time in the past year. The sum of other derivatives (futures, swaps and others) already far exceeds the market capitalization of stocks.

Options appeal to many different market participants and can unlock investments that spot cannot Strategy. Here are a few reasons why people buy or sell options:

- Portfolio protection (insurance). Selling an asset at a price above the market;

- built-in leverage. Options offer a higher notional value than spot;

- Transaction structuring. Express a view through the most cost and/or capital efficient structure, resulting in risk/reward;

- Benefit. Sell options and collect a premium in exchange.

The massive growth of DeFi comes with the expectation of "institutionalization". On-chain opportunities for options, derivatives and structured products are becoming more apparent as blockchain developers build new products and TradFi navigates the compliance minefield. However, the on-chain drive for options today is insignificant compared to offerings from centralized exchanges such as Deribit. The chart below shows options open interest (OI), giving a conclusive idea of the depth of available liquidity:

Compared with on-chain agreements (which usually provide 1-2 short-term terms and 3-5 execution prices), on-chain options are not only easier to obtain liquidity off-chain, but also There is also a wider range of strike prices.

In this article, we consider general trends in the on-chain options space, existing pain points, and how options products can be improved. Clearly, the founders understand the size of the bonus. We’ve seen an explosion of options agreements recently and expect more to come online in the coming months. It was obvious to us that a winner had yet to be established.

Not all options are created equal

Over the past 12-18 months, options The situation has changed dramatically. In early 2020, Hegic was the dominant options protocol, trying to create liquidity pools capable of selling puts and calls. To this day, various iterations of so-called liquidity pools (including AMMs), order books, structured products, and subgroups thereof, named sustainable yield products. Each category has at least a few protocols in operation or under development. The total option TVL is around $1 billion, mainly offered on Ethereum, Arbitrum and Solana.

Our summary of on-chain options is as follows:

Perhaps unsurprisingly, structured products have found the most successful product-market fit to date. These protocols, also commonly referred to as Vaults, allow users to sell volatility (i.e. covered calls or protected puts) at a premium and, for better or worse, are seen by some as an alternative to yield farming. Add in some token rewards, and in some cases, you can see triple-digit APYs. After the initial deposit, the user does not need to take any action, as the option expiration (mostly weekly) and strike price (10-30% relative to spot) are pre-selected and automatically rolled by the protocol.

While the most popular underlying assets are ETH and BTC, there are also products available for AVAX, SOL, and a few other tail assets. These structured products have amassed a TVL of $600 million, with Ribbon Finance leading the category. It’s worth noting that most of them largely use the same off-chain market makers to auction off the options they sell for a premium. We expect long-term winners in the structured product category (as defined today) to deliver products that:

Community-initiated and led products with unique returns.

Most competitive fee structure.

One trend observed this year has been a weakening of short-term implied volatility due to heavy sell-offs from structured product protocols (off-chain market makers buying options Must be hedged by selling similar options on Deribit). This suggests that there may not be enough organic demand to absorb the growing TVL in a structured product, which may continue given the product's simple and attractive benefit proposition to users. Some protocols have begun to address this by allowing anyone to bid on-chain, competing with market makers on pricing, which is a welcome development.

The chart below shows that ETH's implied volatility has declined since mid-December. We believe this is due to lower realized volatility and sales driven by strong growth in structured products in 4Q21.

Selling options close to the expiry date also causes the term structure of implied volatility to be more steep. This is because market makers specifically sell short-dated options to hedge weekly buys from structured products.

Worse for structured products, weaker volatility is observed around the weekly premium auction as market participants know in advance that there will be A lot of option selling and pushing down implied volatility lowers yields for users of structured products. The agreement leaves an open question: should more risk be taken (i.e. underwrite options close to the ATM) to compensate for compressed yields, or should such market forces naturally balance supply and demand for volatility sell-offs? The Friktion team has started to address this by experimenting with different weekly auction times (depending on the asset) to capture higher implied volatility.

In addition to the structured products described above, we have defined a unique set of protocols which we call Sustainable Yield Products. Protocols like Opyn, Brahma.fi, Primitive, Friktion, Vovo vary and it is difficult to come up with a unified term. However, these protocols are offering unique returns or yield products that allow for principal protection while relying on a permanently sustainable source of yield. The applications that have been developed today, we think this part will be greatly expanded in the next year:

- Hedging LP positions;

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- Hedging option risk (for market makers);

- Perps funds payment as income product;

- Selling synthetic options through AMM-focused LPs;

Such products may Unlock use cases at the protocol level where structured products are applied to the protocol’s treasury for risk management and capital efficiency purposes. These protocols are fairly young and niche, but Opyn's squeeth (squared ETH) product has found a niche and is one of the building blocks for the above use case. A product like squeeth actually aggregates liquidity instead of spreading it across different option strike prices and expiration dates.

Next, let's look at order book protocols, which attempt to build options on centralized exchanges. These require high-throughput blockchains to guarantee cheap and fast execution, and as such, Solana has been a top choice in this category. Zeta Markets and Psyoptions aim to provide undercollateralized and cross-margin options trading venues. Additionally, order book protocols are important infrastructure in the options space, as structured products are using them to mint and settle options. We believe that in the long run, the winning product in the order book protocol will be able to:

- Offer a full suite of decentralized derivatives that collectively enhance liquidity and price Discovery while ensuring under-collateralization and cross-margin;

- Ensuring the highest on-chain liquidity (currently lacking, but as private equity investors join market maker, this liquidity is being addressed);

- by allowing modularity of the top-level components (strike, expiration, European and American options, Cash and asset settlement, etc.), to maximize the utility of minting and settlement infrastructure.

Finally, liquidity pool protocols are working to enable on-chain option quoting and underwriting without the help of order book protocols or off-chain market makers. Dopex, Premia, Hegic can be considered advanced Vaults with slight improvements in quoting options and selling them to on-chain buyers. Those deals have yet to pan out, growing to over $100 million in TVL. There are still obstacles:

- The fund pool can only underwrite options, not repurchase;

- Liquidity providers cannot choose the strike price of their options;

- Option pricing ignores the utilization of deposits in the pool;

- Liquidity providers are risky on the underlying, i.e. not hedging like a true market maker.

These products go beyond structured products (Vaults) but, ironically, are at a disadvantage when it comes to finding market fit.

Lyra, Primitive, Pods and others have taken an alternative approach to liquidity pools. These teams are building decentralized market makers, or AMMs for options. We see this group eventually competing with Solana's order book protocol, so the winning product should have a value proposition around capital efficiency (undercollateralization) and option pricing.

Supply and Demand: Where On-Chain Options Fail

Although options are growing in DeFi Faster than other products (until recently), but in terms of number of users, option volume vs. spot volume, and the previously discussed differences from on-chain OI, it hasn't been successful yet. In order to explain this problem, we first look at the source of option liquidity, and then break down the logic behind the supply and demand of option products.

Provide liquidity: traditional market makers on-chain

Traditional market makers need A single venue with the deepest liquidity available, offering multiple derivatives (options, perpetuals) and allowing cross-margining for collateralization. There are several protocols on Solana that take advantage of this, and we expect them to gain significant traction in the coming year, especially as they integrate with Solana's structuring products. These projects have either not yet launched or have recently launched, and we believe this approach has yet to be validated by the market.

Provide liquidity: DeFi-native market maker (decentralized market maker and options AMM)

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We see several pain points in providing on-chain liquidity for options:

By design, most options expire Worthless. This means that LP tends towards a 100% loss most of the time. To mitigate this, protocols need to protect LPs at the expense of capital efficiency, liquidity available in AMMs, and price discovery.

High gas fees. Most options protocols are built on Ethereum, and L1 gas prices have grown. Options are particularly sensitive to gas fees, given the relatively low dollar value of the premium.

Decentralized market makers must have hedging. For a liquidity pool to underwrite options and sell them in both directions, hedging is necessary. The technical implementation of a product like this is perhaps the hardest of all options agreements, as it involves not only dynamically calculating risk for its LPs and pricing options accordingly, but also finding ways to hedge the risk via spot or futures. Ideally, such a product would be built on top of futures products on a scalable blockchain and would have no settlement issues when executing different parts of the trade.

Now let's look at the supply and demand of options products, once liquidity has been established by market makers.

Using Existing Liquidity to Sell

We tend to place structured products in this category One category because they aggregate existing demand for yield (sell volatility), package it, and sell it. Our only reservation is that these options are sold off-chain as there is not enough on-chain liquidity today.

Use existing liquidity to buy

Today's on-chain options products are more seller-oriented rather than buyers. Until recently, we’ve only seen one or two buy-side oriented products that will leverage composability with other DeFi primitives. For example, offering options to hedge LP positions is a way to create natural demand from options buyers and build incremental TVL.

Existing on-chain options products are insufficient to solve the following problems:

DeFi user risk Big preference.

The main reason why options are popular among retail investors-that is, leverage.

Back to the previous point of view, if someone buys highly speculative and deep OTM call options of tail assets (that is, buying the Token that may be parabolic in the spot Convexity), someone must underwrite the option, whether it is a traditional market maker or a native DeFi market maker. The options available for purchase today are more about providing insurance than providing exposure to exponentially rising returns.

Zee Prime’s Options Conclusion

In relation to on-chain options and broader Conclusions about structured products:

Order Books and Decentralized Market Makers. We don't think the two will coexist. Order books will be promoted as they can provide cross-margining and under-collateralization, which is what traditional market makers need to bring deep liquidity. We’re all for seeing DeFi-native approaches to these problems, but most liquidity pools today advertise earning APY on capital without addressing the risk of being an options underwriter who doesn’t hedge risk. These types of options underwriters do not earn uncorrelated returns the way market makers do. Liquidity pools will not be able to compete with order books unless liquidity providers are undercollateralized (via insurance pools, liquidations) and hedged (via spot, futures, or multiple options legs). We see that Lyra (hedged liquidity provider and low collateral) and Primitive (synthetic options in AMM, whose liquidity token can be used as collateral to improve capital efficiency) have two different methods to successfully challenge the order book.

All Structured Product Agreements will ultimately build Sustainable Yield Products. Selling option premiums for income is not a long-term strategy. Yields will fall as more and more TVLs are chasing the same market makers and they need to transfer that risk to someone else. More products will be built that leverage crypto’s native yield streams (staking, perp funding, synthetic option premiums as exchange fees for AMMs, etc.).

On-chain options will be adopted as they are more closely integrated with other DeFi use cases. AMMs, money markets, perpetual futures markets can all drive their own liquidity and adoption by attaching options as risk management tools. This will create a natural demand for on-chain options instead of trying to buy weekly calls and puts close to the spot.

And thoughts on what options products or use cases could be built next.

Volatility as a product. The introduction of Power Perpetuals should allow for the creation of on-chain volatility products that use on-chain oracles (similar to VIX in TradFi, which measures the implied volatility of underwritten option prices). Since perpetual contracts are similar to perpetual options, they are priced considering the entire option chain, rather than a single expiration date, thus aggregating the entire open interest. Since momentum perpetuals have no expiration date, it should be possible to create a volatility pricing instrument that doesn't exist in TradFi or off-chain.

Combine hedging selling with stablecoin lending for cash-settled options. Covered call option writers who want to collect the yield and maintain exposure to the underlying asset, such as ETH, can use this collateral to borrow stablecoins. If the price of the underlying exceeds the strike price at expiration, the proceeds can be used to settle the options contract.

Warrants replace liquidity mining. We have seen a situation where the protocol can replace traditional liquidity mining with Token warrants (smart contracts that enable warrant holders to purchase tokens from the protocol library at a predetermined price). This is similar to OTM call options for holding protocol tokens. Only after reaching a certain Token Warrants can only be exercised when the price is high, and there will be a very low exercise price, which will bring immediate profits to the warrant holders when the exercise conditions are met. This model has several benefits for the protocol and its finances:

Gives room for the token to grow before the warrants can be exercised, giving it a higher Valuation and deeper liquidity, the corresponding Token is sold by hired capital. Ideally, this selling dynamic will be absorbed by the liquidity built up before then, and regular sell-offs of incentive tokens will be contained.

The treasury is effectively raising money from the user because the warrants are exercised at a pre-agreed price.

If the predetermined Token price is not reached, the warrant will never be exercised, and it will be worthless when it expires. The protocol retains its token supply and can be used as rewards in the next iteration of the project.

Finally

Options, structured products and derivatives more broadly are complex. Still, it's clear to us today that winning products in this space have yet to be built. Options took more time to take off than other DeFi applications, but with blockchain scaling issues resolved, more teams were able to test and implement their ideas.

We would love to see options market making native to DeFi win as this will truly democratize the space, which due to its inherent complexity, retail The industry has historically been unable to enter the field. The best protocols in this category try to consider the tasks of traditional market makers from first principles, and then use DeFi-native tools to see them implemented.

We would also love to help our elders configure structured products that will provide a higher ( and sustainable) returns.

DeFi complexity (for better or worse) is advancing, more interdependencies are being created while founders and investors are tinkering with more products .