Detailed explanation of DeFi Option Library (DOV) and its ecology: the road to financial popularization

While options trading is a tool for sophisticated investors in traditional finance, DOV is available to all types of investors and represents an important step towards democratizing mass finance.

Introduction to DOV

DeFi users all know about yield farming. After all, in the early days of DeFi Summer, since most mining did not have a lock-up period, the yield started directly from double digits, and even rose to astronomical figures similar to Ponzi schemes.

However, the initial high returns quickly disappeared, because DeFi protocols mainly provided subsidies to attract users. When DeFi protocols followed suit in the name of “user usage rate”, we have seen many projects unable to hold on and leaving the market one after another. .

In this process, although many users must have obtained short-term benefits, when the funds in the entire market dry up, it is bound to be the last wave of users who will pay the bill.

This unsustainable return leads people to take advantage of volatility to make money on options.

Options have always been an integral part of the TradFi market, and can be used by investors to express directional views and profit from volatility, so many structured products have been formed like Lego blocks. These tools, when implemented properly, can provide superior risk-adjusted capital returns beyond simple buy-and-hold points.

In addition, options have become an important source of income for TradFi, especially in the stock/foreign exchange field, and those investors who hold cash will hedge assets by buying options.

Then for cryptocurrencies and DeFi, if they want to develop further, the liquid options market is crucial because it opens up another dimension beyond spot price movements.

But then again, options strategies are very complex and not everyone has the time or knowledge to execute them in a timely manner, so we need a DeFi Option Library (DOV). 

DOV provides a way for users to easily deposit funds into predefined options strategies to earn income.

Before the creation of DOV, only accredited investors could execute options strategies on their own through over-the-counter (OTC) trading or on options exchanges such as Opyn, while DOV allowed investors to simply deposit assets in a vault, which would then represent the investor to execute strategies that generate revenue. 

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Growth rate of DOV and DeFi market since Q4 2021

In the first quarter of 2021, the growth rate of DOV was similar to that of the entire DeFi market, but in December 2021, DOV began to explode, and TVL tripled in three months. Despite the beginning of a bear market in early 2022, it is still showing resilience.

There are several reasons why DOV has recently become popular and will continue to be in the DeFi space.

First, DOV can generate income by monetizing the volatility of the underlying asset. Crypto options are an important source of returns, and implied volatility tends to be higher than actual volatility, also known as the variance risk premium.

Second, DOV allows scalable trading of non-linear instruments on DeFi.

Options offered by centralized exchanges are the kind of limit order book model, which means that liquidity is spread across different price levels, while DOV concentrates option liquidity on a specific or series of strike prices for a predetermined period, extremely Greatly improved liquidity. And the improvement in liquidity will inevitably spread in CeFi.

In this article, we examine the complexities of DOV, evaluate different types of DOV, and provide our outlook on the landscape.

The inner workings of DOV

The most common strategies implemented by DOV products are covered calls and cash-margined puts.

The covered call option strategy is to sell the call option at a higher strike price than the current market price, and then return the earned option premium to the vault, which is the depositor’s income.

Cash-margined puts are similar, just in the opposite direction.

The vault is open to traders who can deposit assets into the corresponding strategies they wish to participate in. Generally, volatile assets are deposited for bullish selling in the vault, and stablecoins are deposited for selling the vault. The vault then opens options each week and auctions them off to market participants at a predetermined date and time.

Different DOV products have their own mechanisms for minting and selling options to authorized participants, but in general options parameters, such as strike price and duration, are determined based on backtesting results, thus presenting the highest risk to depositors Adjusted return on capital.

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After the auction is completed, the treasury will receive the option fee. When it expires, the depositor can withdraw the deposit or continue to store it in the treasury to participate in the next auction.

Because strategies behave differently, the balance in the vault may be higher or lower than the previous week.

Existing DOV Protocol

Many existing DOV protocols are deployed on various blockchains with the same goal: generating returns for investors.

While most of them have similar strategies (covered calls or cash-covered puts), the ability to cross-DOV protocols varies due to different execution mechanisms, micro strategies, and additional yield coverage.

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Ribbon Finance

Ribbon Finance is a pioneer in the DOV space, allowing users to access crypto-structured products for DeFi.

Ribbon Finance’s flagship product, Theta Vault, allows users to deposit assets and earn yields through a variety of options strategies, and currently offers 11 different vaults covering 5 different tokens for put and covered call strategies.

Since Ribbon Finance went live in April 2021, the vault has generated over $38 million in revenue, with a peak TVL of over $300 million. Institutions such as Dragonfly Capital, Nascent, and Coinbase Ventures participated in the seed round.

StakeDAO

StakeDAO started out as a yield aggregator similar to Yearn Finance, but has since expanded to other yield products such as arbitrage vaults, staking-as-a-service, and DOV.

It launched its first options vault on August 19, 2021, with three vaults mainly around BTC and ETH, operating similarly to Ribbon, both using Opyn as an options market to underwrite their options. 

What sets StakeDAO apart is that assets placed in the StakeDAO Option Vault are immediately transferred to the platform’s passive yield vault, generating additional yield on top of the option premium earned. StakeDAO also allows users to stake LP tokens received from options vaults to earn SDT tokens, increasing yields.

While Ribbon has moved to an active fund management fee model, StakeDAO charges zero platform fees on assets or profits, but a 0.50% withdrawal fee.

StakeDAO has been actively building the Curve ecosystem recently, supporting multiple Curve-based assets and strategies. 

Thetanuts

Thetanuts is a cross-chain structured product protocol designed for everyday investors that radically simplifies the yield earning process and provides option exposure.

Launched in December 2021, Thetanuts is now available on chains such as Ethereum, Avalanche, BNBChain, Polygon, Fantom, Aurora, and Boba. It earned over $24 million in TVL by actively deploying new chains.

Thetanuts charges no fees for its vaults and utilizes off-chain auctions for options trading firms such as QCP Capital and Paradigm, which allows them to offer differentiated options as they are not limited by the availability of on-chain collateral. 

Thetanuts recently closed an $18 million seed round led by Three Arrows Capital, Deribit, QCP Capital, and Jump Crypto. 

Thetanuts stands out from other DOV protocols with the Stronghold strategy.

Stronghold is the aggregation of multiple Thetanuts base vaults to create an index token representing the proportional fair value of the constituent vaults. By exchanging tokens for Stronghold index tokens, investors are essentially investing in a pool of strategies that the protocol optimizes based on backtesting and periodic tuning of parameters, which is similar to a volatility risk premium harvesting hedge fund, but it is on-chain and No charge.

Friction

Friktion is a protocol for DeFi portfolio management products currently on the Solana network, providing risk-adjusted return-generating strategies for DAOs, individuals and traditional institutions.

Friktion’s native portfolio strategy “Volts” is a rendition of the term “Vaults” that allows investors to earn through derivatives arbitrage and volatility strategies.

Launched in December 2021, Friktion has a trading volume of $2.2 billion and offers the largest options market in DeFi — covering 35 assets.

Friktion uses Inertia (cash-settled options in euros) and Entropy (exotic derivatives DEX) for their on-chain settlement. Additionally, Friktion has built an institutional analytics platform for all users to analyze the performance of each vault and its respective strategies.

Friktion, which raised $5.5 million in December from the likes of Jump Crypto and DeFiance Capital, has grown into Solana’s largest protocol for structured products.

Friktion’s product range expands from yield-generating vaults to overall portfolio management services, with a focus on risk management products: such as Volt#05, which will help pool providers hedge against impermanent losses while reap the benefits of high-yield opportunities. Friktion also offers delta neutral strategies that automate delta hedging through their system, in addition to directional strategies such as covered calls and puts with delta.

Katana

After winning the Solana IGNITION Hackathon 2021, Katana officially launched in December 2021. It has successfully built 14 different vaults supporting assets similar to Friktion.

The Katana Vault Mint tokenizes out-of-the-money options on Zeta and sells them to market makers through a competitive Request for Quote (RFQ) auction process. Katana’s TVL is currently $11 million.

Recently, Katana announced a $5 million seed round led by Framework, which will be used to help the protocol scale and become the de facto revenue-generating layer in DeFi.

Potential issues around DOV

While DOVs have the potential to revolutionize yield farming and open up structured products to the masses, they also have potential drawbacks. DOV and systematic volatility selling strategies in the TradFi stock space may be similar to each other. The latter saw several explosions of options sellers, especially after a prolonged period of low volatility from 2016 to 2018, when volatility eventually averaged back sharply, during which a market overcrowded by participants took the same volatility sell. out strategy. As the DOV space expands, it may face the same problem. In addition to this, capital inefficiencies and front-running issues may be the next hurdle for DOV to address before attracting more TVLs.

capital inefficiency

The volatility sell-off has come a long way since the heyday of modern finance, but it has also had its fair share of crashes. Fortunately, most decentralized options vaults today require full collateralization.

For example an ETH bullish vault would require the investor to deposit the underlying ETH into the vault and sell the option for less than the notional amount of the deposited collateral, this is to prevent naked short selling and to protect investors when the strategy is not leveraged When they lose more than they have, the price of increased security is low returns.

Compared to selling options outright, DOV does not allow the holder to close out the position before expiration, which means that if an investor wants to make a profit before expiration, he must make an offsetting trade.

For retail investors who don’t mind delta exposure, locked ETH is an opportunity cost as it may generate returns elsewhere to stack up returns.

Improvements are being made to address DOV’s capital inefficiencies, and ultimately a good balance must be struck between capital efficiency and investor protection.

Ribbon Finance, for example, is considering lowering the collateral required for options vaults. Additionally, Ribbon Finance has integrated with Lido Finance’s Liquid Staking feature, allowing vault depositors to simultaneously receive ETH staking reward option fees.

Early run of DOV

Like any other asset, option prices are determined by supply and demand, and a key component of option pricing is implied volatility. Options are volatility products that represent a specific distribution of returns on the underlying asset. Simply put, if implied volatility is high, option prices will be higher, and vice versa.

This is a question most DOVs are facing right now – what happens if more than $100 million of options are sold on a platform with the same expiry and the same target delta each week? The result is a compression of implied volatility, leading to a subdued yield that is further depressed by the opportunistic frontrunners.

Currently, most DOV auctions are held on Fridays, as market makers can shift risk to the weekend. Given that the weekly options managed by Deribit also expire on Friday, market makers can easily deal with DOV flows, however this allows savvy volatility traders to front-run DOV auctions, which results in lower yields for vault holders .

Some protocols have attempted to change the timing for the benefit of gold depositors. For example, Friktion protocol execution time is adjusted to full day to take advantage of volatile market dynamics and provide users with higher risk-adjusted returns. In addition to this, Ribbon Finance is the first to decentralize and open up bidding to non-market makers.

However, current efforts have not been effective in addressing the supply-demand imbalance, as buyers cannot unwind their options before expiration, meaning they must provide additional collateral on another centralized exchange to close their positions.

Overcrowded and underperforming

As more and more investors flocked to options selling strategies, two things happened.

Option sellers overtake buyers within a specific time interval before and after the DOV auction, and the result is a lower premium for selling options. This is evident in the TradFi space, and DOV is no exception.

First, most DOV participants are immature retail investors who are not price sensitive and mainly seek yield.

Second, the protocol designers are trying to devise a once-and-for-all approach for DOV, allowing vault holders to enjoy a hands-free method of selling options. These dynamics could further depress yields as vault holders systematically and indiscriminately sell volatility even when market conditions suggest poor risk-adjusted returns for volatility selling.

Returning to the TradFi space, given that the influx of options selling strategies has led to a decline in the variance risk premium, option sellers have either increased their selling volume through leverage or opted for more aggressive strike prices to meet their return benchmarks. Doing so accumulates negative Gamma and Vega risks. So if the market moves wildly in either direction, option sellers will perform poorly.

The volatility sell-off could also have a secondary impact on the overall spot market. The crypto options market currently accounts for less than 1% of the entire crypto market, and if this proportion increases, the market structure may change, giving the options market greater leverage.

As options trading becomes more popular in cryptocurrencies, traders who make these markets will hedge more often as they take on more gamma risk, long or short.

Investors should be aware of the risks they take when investing with options vaults. For a covered call option, the overall collateral is limited because if the option is exercised in-the-money, its dollar value will still increase. But selling a put option is a risky attempt, and if the option expires in-the-money, the value will drop.

The future of DOV

Despite the cautionary tales mentioned in the previous section, we believe DOV will revolutionize the DeFi landscape by providing yield and democratizing options for the masses. Here’s our take on how DOV should progress from here.

Innovation, innovation and more innovation

The fact that DOV is still in its infancy is probably the most exciting aspect so far.

DOV currently only offers covered calls and puts, and options are so versatile it allows investors to express specific views. So the future may provide investors with new strategies with attractive returns, such as butterfly spreads, DOV can also study physical settlement for vault holders (if the option is exercised, they do not have to buy or sell the underlying on another exchange) .

In addition to expanding their offerings in this area, protocol developers may also consider improving their implementation methods. Execution can happen every day of the week instead of focusing on one day.

Ribbon Finance, for example, recently announced its planned V3 upgrade, allowing auction execution at random times and sizes.

Paradigm, an institutional crypto liquidity network, has also recently partnered with multiple DOV protocols to improve on-demand liquidity for traders and investors to adjust their options exposure in terms of expiry, risk profile and settlement preferences . This collaboration will significantly increase liquidity throughout the DOV auction process, bringing more benefits to all parties involved.

Finally, DOV could consider tokenizing vault positions to address capital inefficiencies. Thetanuts, for example, will soon convert its vaults into tokenized positions, allowing users to swap in and out early. The token value will reflect the option price of the vault.

Self-discipline and retail education

In addition to the usual smart contract and protocol risks, there are some risks that may be unfamiliar to investors dabbling in options for the first time.

There are plenty of avenues to learn, such as Deribit and GenesisVolatility, which publish useful options content whether you’re a beginner or an expert. Recently, Katana announced that they will be launching Katana Dojo, an educational program designed to provide investors with basic options knowledge.

Investors should not only focus on yield, but should consider the strike price, duration, and willingness to be exercised if the option expires in-the-money. Investors must also understand the management and performance fees of these vaults.

Rather than simply engaging in a systematic sell-off, investors should understand the current volatile environment. For example, in a risk-off environment, where actual volatility may exceed implied volatility, investors should exercise caution before implementing a volatility selling strategy.

Investors are strongly advised to take a hybrid approach to selling volatility. If they feel they are not being adequately compensated for the risk they are taking, they can choose not to participate that week.

Once again, Ribbon Finance V3 will provide a “pause” feature that allows investors to withdraw funds from the vault to improve the user experience. Education and self-regulation are key to protecting investors.

in conclusion

While options trading is reserved for more sophisticated investors in traditional finance, DOV is available to all types of investors and represents an important step towards democratizing mass finance.

DOV has broad prospects.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/detailed-explanation-of-defi-option-library-dov-and-its-ecology-the-road-to-financial-popularization/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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