DeFi Option Vaults (DOVs) provide investors with reliable, attractive yields in all market conditions.
Similar to hedge funds, they democratize access to complex capital management strategies.
Their role in this sector is easy to be overlooked.
- let’s change that
It’s imperative for the continued growth of DeFi to offer access to traditional financial instruments.
Building and innovating on these is extremely cost- and time-intensive as the infrastructure surrounding them has to be built up first.
This infrastructure doesn’t just appear but needs to be incentivized.
Optimally, this is done internally through an increase in volume (and subsequent fee generation) of existing financial instruments.
That is the role protocols offering structured products like DOVs fill.
Structured Products
These are pre-packaged investments linked to digital assets to facilitate highly customized risk-return metrics.
They can take many forms and are customizable but at a most basic level, have a yield-generating and risky component.
By consolidating the payouts of these instruments you get a new type of product with a unique payoff profile.
The ability to position oneself efficiently in accordance with the subscribed narrative and market sentiment with a couple clicks appeals to investors across the board.
To illustrate this further, let’s look at an example by @Vovo Finance
The protocol native to Arbitrum offers ETH UP/DOWN vaults that are “Principal Protected”.
This is achieved through farming with deposited USDC on Curve and using the rewards to open positions on ETH.
Think ETH bottoms out at $700 in 6 months?
You could short it or buy put options. Too risky?
Enter the ETH DOWN vault until you're comfortable with a spot position.
Price falls - earn additional yield
Price rises - capital is preserved
Side Note
These strategies are composable by design, continuously allowing for new iterations, innovations, and advancements to be made.
A protocol allowing for the creation of custom-tailored strategies deployed in user-owned smart contracts comes to mind.
Decentralized Option Vaults (DOVs)
Options trading has been an enormous part of traditional finance. With retail investor platforms like Robinhood gamifying the experience, they have become the dominant tool used by degens.
In theory, they offer access to cheap leverage and are a critical component of the financial landscape.
However, using them correctly requires a deep understanding as the inner workings are quite complex.
More sophisticated strategies require computational work on risk measures like Delta, Gamma, Theta etc. to create an optimal position.
This is where DOVs come in by simplifying the process and offering structured products that deploy user capital in options strategies.
Allowing retail to trade implied volatility with no real knowledge gives them access to higher, organic base yield when compared to lending and staking.
It’s no surprise then that protocols offering DOVs have been outperforming the DeFi sector in TVL growth in 2022.
Side Note - Options
I assume that most readers are already familiar with how options work. If not, here’s a brief overview.
Options represent an agreement between two parties to transact an asset at a specified price before a future date.
There are two types of options that have different payout profiles. Both can either be sold or bought.
Call options - Buyer pays a premium for the right to BUY the asset at an agreed price.
Put options - Buyer pays a premium for the right to SELL the asset.
DOVs are not a passive investment strategy but should be used to amplify yield or adjust market positioning.
Vaults can incur negative yields if the market significantly moves against the underlying strategies.
The main ones here are Covered Calls & Cash-Covered Puts.
Covered Calls
By selling call options on assets already owned, the seller is covered if the asset rises and the option expires "in the money".
In a neutral to moderately bullish environment, this is a low-risk opportunity to earn yield by giving up potential upside.
Cash-Covered Put
The strategy involves selling a put option while setting aside the capital needed to purchase the asset at the strike price.
They work similarly to Covered calls but in the opposite direction, allowing investors to bet prices won’t fall below a certain point.
In either strategy, the optimal return is achieved if the price doesn’t move much.
Crypto is well known to be highly volatile so setting strike prices in accordance with implied volatility is critical.
Backtesting and monitoring volatility are key to optimizing strike prices.
Inner Workings
Traders deposit collateral into the respective strategy; underlying tokens for call-selling or stablecoins for put-selling vaults.
After collateral is pooled, written options are auctioned off to market participants.
Deposits can be withdrawn after expiry.
This process is repeated weekly and is similar across all DOV protocols. There are still notable differences between them.
Namely in the underlying options market, fee structure, handling of auctions, and calculation of strike prices.
Let’s look at some of these protocols.
Ribbon Finance (@Ribbon Finance)
As a pioneer in this space, Ribbon was one of the first protocols allowing investors to access crypto-structured products.
The flagship product, Theta Vault allows users to earn yield by running an automated European options selling strategy.
Other products include:
• a marketplace for institutional unsecured loans (Ribbon Lend)
• a principal protected vault strategy (Ribbon Earn)
• Theta vaults built specifically for DAOs to run covered calls on native tokens (Ribbon Treasury)
Ribbon offers 12 different vaults across 6 different tokens for put-selling and covered-call strategies.
They went live in April 2021 on Ethereum and have expanded to Avalanche and Solana which assisted them to generate $48m in fees since inception.
Notable - Aevo
Planning to expand vertically, the team is building its own decentralized options exchange on a custom EVM rollup.
This promises a plethora of instruments, deeper liquidity, and low fees.
Aevo won't just integrate into Ribbon and open the way to much more sophisticated vault structures and higher efficiency.
It will also attract professional options traders to the space, maybe even siphoning some TradFi players.
JonesDAO (@Jones DAO )
The arbitrum native protocol is built on top of Dopex and backed by influential characters like @TΞtranodΞ 🦇🔊 and co.
Jones Vaults are managed by the team and not decentralized yet, which allows for higher complexity but prevents trustlessness.
The majority of collateral is used to earn yield by writing covered calls.
Depending on the market environment, a percentage of funds is used for hedging purposes.
The strategy isn’t run by an algorithm so the team is responsible but can react quickly in extreme drawdowns.
Next to simple vaults, Jones DAO also offers Metavaults, a novel way to customize the risk profile of an LP position.
Users can switch between Bull and Bear strategies at the end of every epoch.
50% of weekly yields are used to buy either puts or calls on the LP assets.
Notable - jAssets
When depositing into a vault, jAsset tokens are minted to represent that deposit.
Incentivized liquidity pools allow for further rewards while unlocking liquidity for locked assets.
This means higher capital efficiency and higher yield for the user.
StakeDAO (@Stake DAO )
Starting as a yield aggregator like Yearn, StakeDAO has since expanded into other offerings such as Liquid Lockers, Bribing, arbitrage, and option vaults.
These vaults are centered around ETH and BTC and operate similarly to Ribbon on top of Opyn.
StakeDAO managed to get their Passive ETH vault whitelisted on Opyn, increasing capital efficiency greatly.
All deposited ETH earns both the yield generated from options writing as well as the yield accumulated through the passive strategy.
Next to the usual covered call and put-selling strategies, the protocol also offers an ETH Black Swan Hedging vault.
This vault buys ETH puts on a weekly basis and would profit in case the ETH price tanks, e.g. after a black swan.
Opyn Squeeth (@opyn² )
The option vaults we’ve looked at thus far have been simple in design. Let’s look at some more complex products that combine options into a completely new instrument.
Starting with Squeeth by Opyn, the dominant options marketplace player.
Squeeth allows users to long or short the index of ETH^2 perpetually.
With the embedded convexity and Gamma, it provides global options-like exposure with no need for strikes or expiries.
Squeeth consolidates the existing options market liquidity into a single ERC-20.
Longing Squeeth gives investors a leveraged position with limited downside while shorting allows traders to earn funding fees.
Opyn offers automated strategies on top of this new financial derivative.
The "Crab Strategy" combines a short Squeeth and a long ETH position.
This earns yield on funding rates while remaining approximately delta-neutral.
If ETH moves significantly intraday (8%) the strategy can turn unprofitable.
In the future a Bull and Bear strategy will be released, allowing for optimal positioning for investors.
Cega (@cega 🥚 )
The Cega protocol utilizes options to offer an exotic derivative, fixed coupon notes (FCN).
FCNs share characteristics with bonds and equity as they pay periodic yields and return the initial at maturity but are linked in value to the underlying coins.
Investors can choose from 7 vaults and earn daily yield throughout the epoch.
At the end of the 27 days, they get their capital back IF prices haven’t dropped below the “Knock-In Barrier”.
This allows investors to earn continuous yields while being protected from large moves.
This set-and-forget product compounds yields and capital and is perfect for less sophisticated investors.
It’s important to highlight the complexity of FCNs and the risks at play here.
Listing those and going into more detail, would take too long.
Maybe in another thread
Dopex Atlantic Straddles (@dopex (💎, 💎) )
Straddle option strategies are popular and involve longing a Put and Call with the same expiry & strike simultaneously.
The combination results in an inverted triangular payoff chart (next tweet) and earns money if the price moves a lot.
Traders anticipating volatility but not wanting to take directional bets are best served with this strategy.
Atlantic options allow for collateral to be mobile, which Dopex uses to create a more efficient Straddle protocol.
Writers deposit USDC and sell (Short) Puts for a premium. Buyers pay this premium and enter a Long Put.
At the same time, Buyers borrow 50% of the Writer's USDC collateral to buy spot ETH (Long ETH).
The resulting payoff chart is identical to the one above.
Notable - Hedged Straddles
As of now, Writers are exposed to significant downside risk if not hedged properly.
This combined with the small number of available assets limits utility and adoption.
The team is working on hedged straddles, to improve usability and liquidity.
We should have a solid understanding of how DOVs work now.
However, while they liberalize structured products to the masses and innovate the way yield farming works, they also come with potential drawbacks.
Let's look at them.
Capital Inefficiency
Decentralized option vaults require full collateralization to write options.
This prevents “naked selling” and protects investors from losing more than they own.
Similar to the issue of undercollateralized selling, there is no other trustless option.
Locking up collateral increases safety but lowers returns. On top of that, investors aren’t able to take profits before expiry.
Improvements are being made addressing capital inefficiency on multiple fronts:
• Atlantic Options by Dopex mobilizes collateral and puts it to work.
• Ribbon Finance is considering lowering the collateral requirements for vaults and has integrated Lido’s liquid staking.
• StakeDAO deposits underlying assets into another yield-earning strategy before writing options.
All of this increases yields and efficiency.
Front-Running
As with any asset, option prices are determined by supply and demand.
DOVs auction off options to MMs every Friday between 2-11 AM UTC. This allows MMs to offload risk going into the weekend.
What happens when $100m worth of similar options are sold at once?
The systematic selling of volatility puts pressure on options’ implied volatility.
Auction information is publicly available, attracting opportunistic front runners betting on lower volatility ahead of the sell-off.
Volatility is pushed down, giving vault holders lower yields.
According to Paradigm’s research, this lowers the yields by about 5.5% APY.
Scattering auctions across other weekdays would smooth out the market impact and increase yields.
Structural changes to the auction mechanism preventing front-runners would also solve this issue.
Overcrowding and Underperformance
With DOVs becoming more and more popular, the number of option sellers within the time interval around the auctions increases.
This puts pressure on the received premium, lowering yields.
Many DOV participants are retail investors that use the product as a set-and-forget strategy.
A large portion of the vault is systematically selling volatility even when market conditions indicate poor returns.
This effect is already evident in TradFi (graph simplified).
Conclusion
DeFi Option Vaults are a great example of a structured spin-off making a complex product more accessible to retail users.
Smart contracts and protocols make it possible to take away complexity and create custom-tailored strategies.
There are many different protocols, from sector leaders like Ribbon to smaller newcomers like JonesDAO.
Other protocols expand on the idea of DOVs by offering more and more complex strategies.
Especially for those, it’s imperative to educate users to sow realistic expectations.
DOVs also play a significant role as a yield farming tool. Everyone should be aware of issues with sustainability and efficiency when it comes to yields in DeFi.
As one of the few sources of organic yield, DOVs address these issues and offer a way out.
The most exciting part however is that we have just scratched the surface of options strategies.
There are a ton of strategies that can still be adopted from TradFi and some that will be DeFi native and shape the financial future.
We are on a path to democratizing finance for the masses, adopting and innovating as we move further and further.
One day the sector will have evolved enough to form a more efficient, transparent, and open TradFi.
DOVs have a promising future.
This thread is based on two articles linked below.
Special shoutout to the documentation of the mentioned protocols!
And of course @3xcalibur and @Treehouse 🌳 for their awesome research.
treehouse.finance/insights/defi-…
Greetings Insurgents!
3six9 Cognitio Research Wing has published its newest paper
Part I of a new series - Autonomous Hedge Funds
We kick off the series with DeFi Options Vaults
3xcalibur.ghost.io/ms-zzrl7s-kmx8…