Options, one of the most widely traded derivative products in traditional finance, have finally made their way into DeFi. For those that aren’t aware, an option is essentially a contract to buy or sell an asset at a specified price at a specified time. This allows many different strategies to bet on price action or hedge with capital efficiency. While the option markets for traditional equities have been extremely strong to-date, crypto has yet to see much of a market beyond BTC and ETH.
This need for a robust crypto options markets has lead to the innovation of DeFi Options Vaults (DOVs), which allow users to stake their assets into predefined options strategies. So far, the popular strategies have been selling out-of-the-money covered calls and cash-covered puts for a token of choice. The users buying these options need to pay a premium, which is then transferred to the staked user in the form of yield. Through these strategies, the user is essentially earning yield by selling the potential upside or downside to a token’s price.
Here is a visual example for a covered-call strategy with ETH:
While seemingly simple on the surface, DOVs provide a lot of incredible value to DeFi and its users. This is through its ability to provide high yield, scalable trading and liquidity, and the creation of brand new primitives.
Yield
Crypto has always been a never ending search for the highest yields. Whether this be through money markets, providing liquidity on decentralized, exchanges, or high APY rebase tokens. However, the main sources of yield have had their fair share of problems.
For money markets, while yields come from organic demand to borrow, many pools suffer from a “crowding out” effect. There is far more demand for easy yield than there is to borrow, and as lending pools rise in TVL, yields are forced to drop. As a result, many money markets can only pay low single-digit yields without token emissions.
For AMM liquidity, users need to have exposure to two assets, which causes potential impermanent loss and less overall price exposure. Also, most of the rewards are given out in token inflation, which is not a sustainable practice, and the pools suffer from the same “crowding out” effect as money markets.
Rebase tokens, while backed by a treasury of assets, pay out through high token inflation. While the APY can seem like incredible returns, this is assuming the token price doesn’t fall as a result of the enormous money printing behind the scenes.
Yield through DOVs solves a lot of the issues that come with other sources of yield. It doesn’t rely on the endless dilution of token rewards, it doesn’t require manual maintenance, it doesn’t suffer from crowding out, and the user isn’t at risk to impermanent loss. The only risk is if the options sold expire in profit, where the user would lose out on the potential upside but still be up in USD terms. It is a very simple process that provides the user with high yield.
Here is a breakdown comparing the yield components of these different strategies
In addition to the high organic yield that comes from collecting premium alone, vaults actually allow the user to potentially benefit from other forms of yield as well. For example, if you deposited SOL into a DOV, the vault could potentially stake the SOL on the network prior to the expiry date, so the user earns both the premium yield plus the yield from staking. Protocols could also give out extra rewards in their native token to attract depositors. Yields could then stack on top of each other in an automated fashion. Dopex is reported to be developing vaults with six forms of potential yield. These yields could not only be extremely high, but also long-term sustainable, which makes it very attractive for all potential investors.
Altcoin Liquidity
In addition to really high yields, DOV products are also bringing much-needed liquidity to the altcoin options market. The current options market for crypto is dominated heavily by BTC and ETH, and by the Deribit exchange. The market for any other coin has essentially been absent so far, and is extremely hard for centralized entities to bootstrap.
DOVs by design incentive deposits for option liquidity. TradFi markets can then look at these DeFi options markets to gauge whether there is sufficient enough demand for them to spin up trading themselves. This is incredible because rather than CeFi leading the way for increased liquidity, it is DeFi that is in charge. This will lead to a flywheel of more and more altcoin liquidity added as DOVs gain adoption, and could allow DeFi to become the primary place such options are traded.
Having altcoin vaults is also extremely beneficial to the overall crypto markets, because there is now a potential source of high yield for any token with enough trading demand. Yield is not limited to governance token inflation or staking rewards. It will also help significantly improve spot markets for altcoins, as is the result of all derivatives products.
Brand New Innovations
Beyond just the ability to earn high yield, DOVs are also providing some incredible innovations that will allow brand new DeFi composability, and the ability for users to trade, hedge, and earn yield.
The first innovation that DeFi Options provide is the ability to liquidate collateral in a non-linear fashion. Without getting too technical, this is necessary in order to have an options market work at scale, and no centralized entity has come up with an easy solution to do so in an automated and trustless fashion. DOVs, by having users put up their own liquidity in these vaults, allow all the elements that need to be trustless to execute on-chain, while the risk management is done off-chain. This elegant solution for non-linear liquidations will likely be replicated for many similar financial instruments and will change the way certain products are structured and traded forever (QCP Capital).
Innovations are also coming in the form of brand new products and primitives. For example, Dopex is releasing a REDACTED vault, allowing users to use options to bet on the interest rates of Curve pools, incentivizing vault participation for protocols in the Curve wars. This will likely be the first of many product iterations to come from Dopex, and similar innovations are happening with other options protocols.
You can imagine the creation of options contracts and DOVs for things beyond just normal governance tokens, or even options as a financial instrument. As DOVs continue to get built out there will likely be a lot of creativity and composability as a result of this primitive.
DOV Adoption
There have been many different options protocols across many different chains that have looked to create DOVs and structured products centered around options. The total TVL is around $850 million, and has really gained momentum in Q4 of 2021. The highest TVL of any protocol is Ribbon Finance, at around $275 million in TVL. DeFi Llama has a dedicated page for options TVL for anyone looking for a full list of protocols.
Given the yield potential and the brand new primitives that are just making their way into production, this is certainly only scratching the surface of what is possible.
Deribit, the leading options exchange which accounts for over 80% of BTC and 90% of ETH options markets, has around $7 billion in open interest for BTC and $5 billion in open interest for ETH every day. This is far more than the TVL sitting in DeFi options protocols.
In order to get a gauge on how much growth could be possible in the near term, I tried to estimate an equal proportion of open interest based on market capitalization of ETH versus the largest L1 assets. Here is the growth potential based on an estimated $6.5 billion total open interest for ETH ($5 billion / 80%)
While this isn’t the absolute best possible method of estimation, there is clearly a lot of room for growth in DOVs and options markets for Layer 1 assets, which are the first group of assets these DOVs will target. The growth could be exceptionally pronounced for the numerous governance tokens with no current vaults.
While many of the traditional DeFi yield products got their start on Ethereum, DOVs were created at a time with more chain variety. As a result, Ethereum has had to actually compete for market share out the gate. This could give other chains a chance to become a leader in this category.
Here is an estimate of the current TVL breakdown by blockchain:
Although Ethereum enjoys a lead currently in terms of options TVL, Solana is not too far behind at 24% of the total market. With the recent growth the chain has seen in options protocols (including a recent Ribbon x Zeta announcement) and the potential for higher frequency trading given Solana’s design, this may end up as the go-to chain for options. Ethereum Layer 2 options such as Arbitrum and Optimism are also showing signs of success so far, given lower fees than Ethereum’s base layer. However, it is far too early to tell which chains will dominate going forward, and I am curious to see how this progresses.
Conclusion
Overall, DOVs are an incredible DeFi innovation that allow users to get high sustainable yield, and opens up the way for more robust altcoin liquidity across the board. We are very much in the early days of DOVs, and there will be a lot of experimentation with respect to the vault offerings and strategies as teams continue to build out their products and fight for adoption. While Ethereum has gained the largest amount in TVL currently, Solana looks to be a main competitor, given its construction focused on higher frequency trading for decentralized exchanges. Similar to the great success of AMMs and money markets in the past few years, DOVs are likely to become a staple DeFi product for years to come.
Sources
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