Will On-Chain Options Ever Take Off In Defi?

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Over the last few years, trades of options con­tracts have been explod­ing. In fact, 2022 marked the third con­sec­u­tive year in which con­tracts in sin­gle-stock and index options in the U.S. set a new record , more than dou­bling from where they stood only three year ago.

Last year marked the first time U.S. stock options sur­passed 10 bil­lion con­tracts in a year. How­ev­er, while options are also avail­able on cryp­tocur­ren­cies , they remain far behind stock options in pop­u­lar­i­ty. Accord­ing to Wave Finan­cial, the dai­ly cryp­to options vol­ume has hov­ered just below $1 bil­lion on cen­tral­ized exchanges.

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On-chain options takes cryp­to deriv­a­tives anoth­er step fur­ther, but they are still far less pop­u­lar than dai­ly cryp­to options, account­ing for a dai­ly vol­ume of less than $10 mil­lion. As a result, Wave Finan­cial declared ear­li­er this month that on-chain options ‘are the next fron­tier in DeFi.’

Table of Con­tents show 

  • 1.
    what are on-chain options?

  • 2.
    a chang­ing landscape

  • 3.
    struc­tured products

  • 4.
    poten­tial prob­lems with on-chain options

  • 5.
    some ideas for on-chain options 

What Are On-Chain Options?

Options are con­tracts that give the hold­er the option but not the oblig­a­tion to buy or sell the under­ly­ing secu­ri­ty at a par­tic­u­lar price on or before a par­tic­u­lar date. Call options allow hold­ers to pur­chase at the spec­i­fied price by a par­tic­u­lar date, while put options allow them to sell at the spec­i­fied price by a par­tic­u­lar date.

When an option is referred to as ‘on-chain,’ it’s a con­tract that’s been record­ed on a blockchain. Pur­chas­ing on-chain options requires a pro­to­col like Hegic.

Some investors pur­chase options to hedge against poten­tial volatil­i­ty, although in cryp­tocur­ren­cy, volatil­i­ty is vir­tu­al­ly a giv­en. Oth­ers pur­chase them as port­fo­lio pro­tec­tion because they might enable them to sell their assets at a price that’s high­er than what the broad­er mar­ket is sell­ing at. Anoth­er com­mon rea­son to buy options is to gen­er­ate yield by sell­ing option­al­i­ty and then col­lect­ing a pre­mi­um in exchange.

In the last cou­ple of years, much of the growth in decen­tral­ized finance (DeFi) has been the result of expec­ta­tions that insti­tu­tion­al investors will become major play­ers in the mar­ket. How­ev­er, traders have yet to ful­ly tap into the advan­tages offered by on-chain options.

A Chang­ing Landscape

On one hand, it’s easy to see why off-chain options are more pop­u­lar right now. There is inher­ent­ly more avail­able liq­uid­i­ty off-chain, and there’s a wider array of matu­ri­ties and strike prices avail­able via off-chain options. accord­ing to zee prime cap­i­tal , on-chain pro­to­cols may offer only one or two short-dat­ed matu­ri­ties with only three to five strike prices.

How­ev­er, the options land­scape in defi has been chang­ing rapid­ly, and the last 12 to 18 months have been crit­i­cal for this asset class. Hegic was the dom­i­nant options pro­to­col at the begin­ning of 2020, try­ing to cre­ate liq­uid­i­ty pools for sell­ing calls and puts.

Three years lat­er, the on-chain options land­scape includes var­i­ous forms of pro­to­cols that Zee Prime cat­e­go­rizes as Liq­uid­i­ty Pools, Order-Books, Struc­tured Prod­ucts and Sus­tain­able Yield Prod­ucts. One of the more pop­u­lar groups of pro­to­cols is Struc­tured Prod­ucts, more com­mon­ly known as Vaults.

Struc­tured Products

They allow users to sell volatil­i­ty in var­i­ous ways, like by under­writ­ing cov­ered calls or pro­tect­ed puts. In exchange, the users receive a pre­mi­um that some see as an alter­na­tive to liq­uid­i­ty min­ing. Just as with oth­er options strate­gies, investors who uti­lize this options pro­to­col don’t have to do any­thing after mak­ing the ini­tial deposit.

Most options mature at the end of the week, and the strike prices at 10% to 30% ver­sus the spot price are pre-select­ed and rolled auto­mat­i­cal­ly by the pro­to­col. Unsur­pris­ing­ly, Ethereum and bit­coin are the most pop­u­lar under­ly­ing secu­ri­ties for these options pro­to­cols, although options on a select num­ber of oth­er cryp­to assets are also available.

Zee Prime Cap­i­tal observed one recent­ly devel­oped, options-relat­ed trend, which is damp­en­ing of short-term implied volatil­i­ty due to heavy sell­ing from pro­to­cols that fall under the Struc­tured Prod­ucts cat­e­go­ry. The firm not­ed that off-chain mar­ket mak­ers who buy those options have to hedge by sell­ing sim­i­lar options on Deribit.

As a result, it sug­gest­ed that the nat­ur­al demand might not be great enough to absorb the grow­ing total val­ue locked in Struc­tured Prod­ucts. Zee Prime Cap­i­tal expects inter­est in Struc­tured Prod­ucts to con­tin­ue grow­ing due to its attrac­tive yields. It also not­ed that some pro­to­cols start­ed to address the issue by allow­ing investors to bid on-chain while com­pet­ing on pric­ing against mar­ket makers.

Anoth­er prob­lem for Struc­tured Prod­ucts is that volatil­i­ty is damp­en­ing around the time when week­ly pre­mi­ums are being auc­tioned. Mar­ket par­tic­i­pants know that heavy options sell­ing is going to occur around that time, so they push implied volatil­i­ty low­er, leav­ing less yield for users of Struc­tured Products.

As a result, pro­to­col users and devel­op­ers must address var­i­ous issues dur­ing this peri­od of grow­ing pains. For exam­ple, they’ll have to con­sid­er whether to take more risk, which can be done in var­i­ous ways like under­writ­ing the options clos­er to the at-the-mon­ey lev­el to com­pen­sate for the com­pressed yield.

On the oth­er hand, the mar­ket force could be allowed to nat­u­ral­ly bal­ance the sup­ply and demand over sales of volatil­i­ty. For exam­ple, Fritk­tion is already work­ing on address­ing this through exper­i­men­ta­tion with dif­fer­ent auc­tion times for dif­fer­ent assets through­out the week. Those exper­i­ments are aimed at try­ing to cap­ture high­er implied volatility.

Poten­tial Prob­lems With On-Chain Options

As the num­ber of on-chain option pro­to­cols grows, it should become clear which are more promis­ing than oth­ers. How­ev­er, no asset class is per­fect, so investors should also learn the risks asso­ci­at­ed with an invest­ment before they buy in.

Zee Prime Cap­i­tal not­ed that options have been grow­ing faster than oth­er DeFi prod­ucts until recent­ly. How­ev­er, the dif­fer­ence has been rel­a­tive­ly small con­sid­er­ing the num­ber of users, options ver­sus spot vol­umes, and oth­er issues.

For exam­ple, liq­uid­i­ty is always an issue dur­ing the ear­ly days of an asset class, and on-chain options are no dif­fer­ent. Zee Prime sug­gest­ed that tra­di­tion­al mar­ket mak­ers may need a sin­gle venue with greater liq­uid­i­ty sup­port­ing mul­ti­ple deriv­a­tive prod­ucts while allow­ing under-col­lat­er­al­iza­tion with cross-mar­gin­ing. Sev­er­al pro­to­cols are doing this on the solana blockchain, and the firm expects them to gain sig­nif­i­cant trac­tion over the next year.

Of course, most options expire worth­less, so on-chain pro­to­cols must pro­tect investors at the expense of cap­i­tal effi­cien­cy, liq­uid­i­ty and price dis­cov­ery. Gas fees are a sig­nif­i­cant bar­ri­er, espe­cial­ly as they have been ris­ing recent­ly. Most of the option pro­to­cols have been built on Ethereum amid ris­ing gas prices, and options are espe­cial­ly sen­si­tive to gas fees because pre­mi­ums have com­par­a­tive­ly low val­ue in dol­lar terms.

Final­ly, decen­tral­ized mar­ket mak­ers must be hedged so that they can pro­vide the liq­uid­i­ty to under­write options and be able to sell them both ways. This issue must also be han­dled via the options pro­to­col, which can be challenging.

Some Ideas For On-Chain Options

Going for­ward, Zee Prime Cap­i­tal expects to see more prod­ucts built to tap the cryp­to-native sources of yield like stak­ing. In turn, the firm also not­ed that sell­ing options pre­mi­ums for income isn’t a sus­tain­able strat­e­gy over the long term. As a result, it expects all Struc­tured Prod­ucts pro­to­cols to even­tu­al­ly build Sus­tain­able Yield Products.

The firm also pre­dicts that on-chain options will more close­ly inte­grate with oth­er defi use cas­es. Auto­mat­ed mar­ket mak­ers, mon­ey mar­kets and per­pet­u­al futures mar­kets could the­o­ret­i­cal­ly all dri­ve their own liq­uid­i­ty and adop­tion by adding options to assist with risk man­age­ment. This would cre­ate nat­ur­al demand for on-chain options.

Have you invest­ed in on-chain options? Share your insights in the com­ments sec­tion below.

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