Why are DeFi options protocols generally underdeveloped?

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 they can unleash investment strategies that spot stocks cannot. Here are a few reasons why people buy or sell options:

• Portfolio Protection (Insurance). sell assets at above-market prices;

• Intrinsic leverage. Options offer a higher notional value than spot;

• Transaction structuring. Express risk/reward through the most cost and/or capital efficient structure;

• income. 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 open interest (OI) for options, giving a conclusive idea of the depth of available liquidity:

Compared with on-chain agreements (which usually provide 1-2 short term and 3-5 strike prices), on-chain options not only have liquidity more easily available off-chain, but also have a wider range of option expiry and 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

The options landscape has changed dramatically over the past 12-18 months. 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 about $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 to that some token rewards, and in some cases, you can see up to triple-digit APY. After the initial deposit, the user does not need to take any action, as option expiration (mostly weekly) and strike price (10-30% relative to spot) are pre-selected and rolled automatically 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 the long-term winners in the structured product category (as defined today) to offer the following :

• A community-initiated and led product with unique rewards.

• The most competitive fee structure.

A trend observed this year has been a weakening of short-term implied volatility due to heavy sell-offs from structured product agreements (off-chain market makers who bought options had to hedge 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 closer to expiration also creates a steeper term structure for implied volatility. 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 weekly premium auctions, as market participants know in advance that there will be significant option selling and push implied volatility lower, making Lower 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 above structured products, we have also defined a unique set of protocols, which we call Sustainable Yield Products. Protocols like Opyn, Brahma.fi, Primitive, Friktion, Vovo are all different 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. Applications that have been developed today, we think this part will expand greatly in the coming year:

• Hedged LP positions;

• Hedging options risk (for market makers);

• Payment of Perps funds as income products;

• Sell synthetic options through AMM centralized LP;

Such products have the potential to unlock use cases on a protocol-to-protocol level, where structured products are applied to protocol treasuries for risk management and capital efficiency purposes. These protocols are fairly young and niche, but Opyn's squeeth (square ETH) product has found a suitable market 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 establish 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 under-collateralized 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:

• Offers a full suite of decentralized derivatives that together enhance liquidity and price discovery while ensuring under-collateralization and cross-margining;

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

• Maximize the utility of minting and settlement infrastructure by allowing modularity of building blocks on top (strikes, expirations, European vs. American options, cash vs. asset settlement, etc.).

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. These 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 to underwrite the strike price of their options;

• Option pricing ignores the utilization rate of deposits in the pool;

• Liquidity providers are risky on the underlying, i.e. not hedging like true market makers.

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 the approach of alternative 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 the growth rate of options in DeFi is faster than other products (until recently), it has not been successful in terms of the number of users, option volume and spot volume, and the difference from on-chain OI discussed earlier. In order to explain this problem, we first look at the sources 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 require a single venue with the deepest available liquidity, offering multiple derivatives (options, perpetuals), and allowing cross-margining for collateralization. There are several protocols leveraging this on Solana, and we expect them to gain significant traction in the coming year, especially as they integrate with Solana's structured 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 option AMM)

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. Given the relatively low dollar value of the premium, options are particularly sensitive to gas fees.

• Decentralized market makers must have hedging. For a liquidity pool to underwrite options and sell them in both directions, hedging is necessary. The technical realization of a product like this is perhaps the hardest of all options agreements, as it not only involves 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.

Sell using existing liquidity

We tend to put structured products in this 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.

Buy using existing liquidity

Today’s on-chain options products are more geared toward sellers 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 users have a high appetite for risk.

• The main reason options have become popular among retail investors is leverage.

Going back to the earlier point, for someone to buy a highly speculative, deep OTM call option on a tail asset (i.e. buy convexity on a token that may be parabolic in spot), someone has to underwrite the option, either traditional or DeFi native market maker. The options available for purchase today are more about providing insurance than providing exposure to exponentially rising returns.

Zee Prime Options Conclusion

Conclusions related to on-chain options and structured products more broadly:

• 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 are all for seeing a DeFi-native approach to solving these problems, but most liquidity pools today advertise earning APY from capital without addressing the risk of being an option underwriter who does not 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 Lyra (hedged liquidity providers and low-collateralization) and Primitive (synthetic options in AMMs whose liquidity tokens can be used as collateral, thereby improving capital efficiency) as two different approaches 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 ideas on what options products or use cases could be built next.

• Volatility as a product. The introduction of Power Perpetuals should allow building 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 tool that doesn't exist in TradFi or off-chain.

• Combine hedging selling with stablecoin lending for cash-settled options. Covered call option sellers 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 see a situation where the protocol can replace traditional liquidity mining with token warrants (smart contracts that give warrant holders the right to purchase tokens from the protocol library at a predetermined price). This is similar to OTM call options for holding protocol tokens. Warrants can only be exercised when a certain token price is reached, and there will be a very low exercise price, thereby bringing immediate profits to warrant holders when the exercise conditions are met. This model yields several benefits to the protocol and its finances:

1. To provide tokens with room to grow, with higher valuations and deeper liquidity, before warrants can be exercised, corresponding tokens are sold by employed capital. Ideally, this selling dynamic will be absorbed by the liquidity built up prior to this, and periodic sell-offs of incentive tokens will be contained.

2. The Treasury is effectively raising money from users because the warrants are exercised at a pre-agreed price.

3. If the predetermined token price is not reached, the warrants can never be exercised and expire worthless. The protocol retains its token supply and can be rewarded in the next iteration of the project.

at last

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 a space that has historically been inaccessible to retail due to its inherent complexity. 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'd also love to help our elders configure structured products that will provide higher (and sustainable) returns than the TradFi tools MBA training consultants sell them.

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

Original Author: Rapolas, Zee Prime Capital

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

Compilation: Eva, Chain Catcher