Understand Divergence in Five Minutes: Using Highly "Customized" Options Products for Risk Hedging

*Source: ChainNews, author: *Groot.

The historic cryptocurrency market crash on May 19 brought about massive liquidations on centralized exchanges and ignited intense discussions about the end of the bull market. At the same time, it subjected the DeFi market, which had been immersed in the joys of the bull market for the past year, to a "bloody baptism." The significant liquidation volume led to extreme congestion on the blockchain, and the exorbitant Gas fees reflected the helplessness of market participants who found "nowhere to hide" when market risks erupted.

For the DeFi market, although the variety of Lego components within the ecosystem is quite considerable, the issue of effectively hedging price volatility risks for on-chain assets—especially LP tokens used for liquidity mining and native tokens for mining rewards—has not been effectively resolved. Existing DeFi insurance products support relatively singular insured objects, making effective risk hedging difficult. The Divergence introduced in this article aims to utilize highly "customized" options products for risk hedging, thereby addressing this issue.

1. What is Divergence?

Divergence is a decentralized volatility derivatives platform designed to provide users with a simple solution to hedge their exposure to the inherent volatility risks of DeFi assets. Additionally, it offers liquidity providers a way to earn volatility premium income, serving as an extra source of income beyond lending yields and liquidity mining rewards from other protocols.

The first product is a binary options market based on AMM, covering underlying asset prices, interest rates, and even staking rewards, among others. Currently, liquidity for major options products is concentrated on centralized exchanges, primarily trading mainstream assets like BTC or ETH. Divergence's binary options products allow users to specify DeFi trading pairs, and the funds used to provide liquidity and trade are also DeFi assets, which can even include second or third-layer assets within the DeFi ecosystem, effectively enhancing the composability of options products.

In simple terms, Divergence supports the creation of options products using almost all fungible tokens, such as interest rates from mainstream lending products like Aave and Compound, staking rewards from different PoS assets, as well as various on-chain pegged assets and decentralized stablecoins. Furthermore, users can set their own strike prices and expiration times. Since the protocol does not require that the collateral and the underlying asset of the options be the same, it is also possible to create non-standard options (exotic options) using stablecoins or other assets.

Divergence addresses market continuity issues through liquidity pools that automatically roll over, thereby reducing the cost for liquidity providers to manage expiration issues in a smart contract environment while ensuring the sustainability of their own liquidity. This means that such products can achieve continuous market price discovery and provide the potential for future volatility indices and index derivatives.

Additionally, for liquidity providers with smaller capital scales, maintaining options positions with different strike prices and expiration dates in centralized order book exchanges inevitably leads to a significant reduction in capital utilization. In contrast, liquidity providers on Divergence can directly use LP tokens to participate in market making, and only need to provide one type of token asset in a pool to mint binary options. The sale and purchase of options tokens do not require over-collateralization, which effectively enhances the overall capital utilization efficiency of the system.

2. Why Choose Binary Options?

At the protocol level, Divergence focuses on building inclusivity for derivatives to fully leverage the volatility of the expanding decentralized finance space. Given that current DeFi market participants are exposed to various financial risk exposures, utilizing dynamically generated derivatives for risk hedging is a market necessity, and binary options can serve as an ideal "solution."

Unlike futures products, options provide a nonlinear risk-return structure, allowing option buyers to build leveraged positions in assets at a lower cost than direct trading. A binary options portfolio can be constructed from the volatility risk exposures of different DeFi assets, many of which cannot currently be found in the options markets of centralized exchanges. Additionally, binary options have an ideal pricing mechanism that allows buyers and sellers to exchange a predetermined number of tokens at the expiration of the options. In the Divergence pool, if the binary options tokens meet the strike price at expiration, they can receive a portion of the collateral; otherwise, the return is zero. The prices of binary call and put options are quoted and traded in terms of collateral, and the sum of both always equals one unit of collateral. This pricing mechanism is much easier for retail investors to understand compared to traditional standard options. For example, the maximum return on a call or put option purchased with 0.5 units of collateral is one unit of collateral, or double the principal.

Overall, Divergence aims to enhance the composability, continuity, and capital efficiency of on-chain options markets by establishing a financial risk management and yield enhancement layer for other DeFi protocols, thereby incentivizing further adoption of various DeFi protocols.

3. How is the AMM-based Binary Options Market Achieved?

Liquidity providers mint an equal number of binary options tokens for both calls and puts by depositing a certain amount of collateral, which is then injected into the liquidity pool. The liquidity pool creator can define the initial pricing, strike price, and expiration period for the call and put options during market making. As the prices of the call and put options deviate from the initial pricing, once more liquidity funds are injected, the smart contract will calculate the number of binary options tokens that can be minted based on the proportion of collateral belonging to the call and put options at that time.

When a trader deposits collateral into the liquidity pool to buy a call option, the collateral they add will be allocated to the call option side. According to the product formula for the call option side, the trader will be able to purchase call option tokens at the updated price. At this point, the put option price will be updated to 1 minus the new call option price, and subsequently, the collateral and product formula for the put option side will be updated accordingly. Meanwhile, the smart contract will also calculate the surplus amount of collateral added to the liquidity pool.

Additionally, Divergence optimizes the issue of maintaining liquidity continuity for derivatives tokens with most time parameters. Expired options do not require the creation of new contracts; a single options market will continuously use the same contract, with each expiration date representing a "round" and the state of the smart contract. As options are continuously rolled over after expiration, liquidity will remain in the pool until withdrawn.

Before the options expire, liquidity providers can withdraw their liquidity shares under the condition that the maximum claim requirements for the options sold are met and early withdrawal fees have been paid. A certain number of options tokens will be burned in proportion to the liquidity withdrawn. Since liquidity reserves are provided to meet the potential maximum claim requirements of the options, even if all liquidity providers withdraw their liquidity before expiration, the smart contract system will still retain liquidity to ensure normal trading for users.

4. Development Roadmap

In addition to launching AMM-based binary options products, Divergence will also integrate with Ethereum Layer 2 in the future and develop a smart pricing algorithm called "SPQA" to dynamically adjust based on real-time volatility changes, helping liquidity providers to update pricing according to market conditions. Furthermore, Divergence plans to offer "portfolio margin" for LPs and add leverage to the smart contract system, further enhancing the capital utilization of DeFi participants. All of the above functionalities will be determined by the community through a governance module regarding the future rollout pace.

In the upcoming 2.0 version scheduled for release in the third quarter of this year, Divergence will also introduce a volatility index and related index derivatives, allowing users to go long or short on tokenized volatility assets. Besides being used for risk hedging, these products may also evolve into an independent decentralized volatility market similar to the VIX index derivative market.

References:

https://medium.com/divergence-protocol/introducing-divergence-7fb73ae8a0a4

https://twitter.com/divergencedefi