Why do people say that DeFi options vaults will change the rules of the DeFi game?

Original Title: An Explanation of DeFi Options Vaults (DOVs)

Author: QCP capital

Translated by: Dong Yiming

DeFi Options Vaults (DOVs) have become a trend in the second half of 2021, attracting not only the interest of retail investors but also large institutional participants. Starting from scratch, DOVs have grown exponentially, becoming a major component of the total locked value of DeFi options, which stands at $700 million, with nominal trading volumes reaching billions of dollars each month.

1. What are DeFi Options Vaults (DOVs)?

The beauty of DOVs lies in their simplicity. Investors simply "stake" their assets into the vaults, which then deploy those assets into options strategies. Before DOVs, only accredited investors could execute options strategies through over-the-counter (OTC) trading or through options exchanges like Deribit.

The strategies deployed by DOVs so far include vanilla covered calls and cash-secured puts, which provide the highest base yields in DeFi (averaging 15-50%). Most importantly, token rewards are also distributed, offering users even higher returns.

In some cases, the collateral in the vaults can also earn staking/governance rewards, creating three sources of yield within a single vault: options premiums, token rewards, and collateral yield, resulting in significantly high and sustainable returns, which is unprecedented in DeFi.

On the other hand, market makers compete to buy these options from the vaults. They pay premiums upfront for these options, thus providing high base yields.

2. Why do DOVs change the game?

1. DOVs bring high organic yields to DeFi

The main source of yield in DeFi is token rewards. While money market protocols, AMMs, and the recently proposed Protocol Owned Liquidity (POL) by OHM do provide some small base yields, achieving high annualized returns heavily relies on token distribution.

The problem here is that yields are primarily synthetic and circular, heavily dependent on the rise in token prices. If a large number of new entrants enter and then exit DeFi, causing token prices to crash, yields will flatten out, ending the virtuous cycle we see in DeFi.

The base yield of DOVs does not rely on token rewards at all. DOVs effectively monetize the high volatility of the underlying assets and inject this yield into DeFi by paying options premiums. It also addresses the diminishing returns (or crowding out effect) caused by the increasing size of LP pools, as the base yield comes from large external options markets.

This real base yield is key to the long-term sustainability and scalability that is missing in DeFi. Shifting from the Ponzi economics of token creation and distribution to capturing the real value of natural growth from potential market structures and trading volatility.

DOVs effectively democratize the crypto space elements that financial institutions have long coveted, with implied volatility (IV) being 10-20 times that of traditional financial instruments. Institutional participants have been rushing to offer this service to Tradfi investors, building crypto asset products with risk-adjusted returns far exceeding any products currently available. DOVs make this alpha accessible to everyone.

2. DOVs allow scalable trading of nonlinear tools on DeFi

The market structure of DeFi is well-suited to manage delta-1 or linear tools. Spot trading, over-collateralized lending, and margin perpetual contracts have been expanded through smart contracts in terms of effective liquidation mechanisms. However, when it comes to nonlinear tools like options, DeFi has encountered difficulties. Options traded on DeFi order books are not scalable.

To be fair, nonlinear liquidation is a challenging problem to solve. Even centralized exchanges like Deribit encounter difficulties in managing nonlinear liquidation. For the liquidation of large options portfolios, delta (or spot risk) can first be managed by executing perp or futures positions on that portfolio. Then, with the active participation of intermediaries, other greeks (nonlinear risks) in the portfolio are systematically liquidated over time.

DOVs provide a better solution to this problem. DOVs utilize a hybrid DeFi model where investment, collateral management, price discovery, and settlement occur on-chain, while nonlinear risk management is conducted off-chain. In this model, all elements that truly need to be trusted are executed on-chain, yields are pre-realized, and the entire process is completely transparent.

DOVs effectively solve this problem from the seller's perspective. They obtain collateral from DeFi investors and match it with market makers offering high base yields. All options contracts traded through DOVs are fully collateralized, completely eliminating the need for liquidation. Then, options contracts can be tokenized and actively traded on DeFi through RFQ (Request for Quote) or order books in a scalable manner without a liquidation mechanism.

The solution sounds simple, but its impact is enormous. This is pure DeFi innovation. Nonlinear liquidation without intermediaries is a problem that Tradfi has never needed to solve. If options trading can be purely managed at scale by smart contracts in a transparent and sustainable way, it could fundamentally change the structure and trading of financial products.

3. DOVs will become the liquidity cornerstone of the altcoin options market

The crypto options market is dominated by BTC and ETH, which are the only two tokens offered on Deribit. The Deribit order book is the core liquidity venue for BTC and ETH, which is also reflected in the OTC market. Options outside of BTC and ETH have almost no liquidity.

Many may not remember that even at the beginning of 2020, ETH options lacked liquidity and were nearly impossible to trade on Deribit. QCP was one of the main participants injecting vitality into the ETH options market, leading to more market makers entering the market and providing bids by injecting huge volumes across a wide range of spreads, thereby increasing the thickness of the ETH order book. Fast forward a year and a half to now, the ETH volume market can be said to be more liquid and as large as the BTC volume market.

We have tried for some time to do the same for other tokens, but with little success. To truly activate the volatility market, it needs a scalable venue and key liquidity injections to incentivize traders, investors, and market makers to participate.

Ironically, we see DeFi successfully bringing life to altcoins that CeFi has failed to support. DOVs have become the largest trading venue for altcoins, establishing vaults for more tokens like ALGO, LUNA, AAVE, AVAX, etc.

As a venue and source of liquidity for altcoin options, DOVs are rapidly becoming the liquidity cornerstone for altcoins. This liquidity will inevitably spill over into CeFi. Now that demand exists, exchanges will confidently list more altcoins, and OTC traders will be able to tighten the basis and push altcoin options products received through DOVs.

This is significant; we are seeing DeFi lead CeFi as the initiator of liquidity, rather than merely being a layer built on CeFi driven by multi-layer token incentives.

More importantly, the emergence of altcoin vaults in DOVs will provide a viable high-return alternative source for holders of various tokens, rather than just holding and staking rights. Investors, speculators, foundations, and project treasuries clearly see the value of monetizing their large coin inventories and are beginning to flock to the vaults. The demand for these altcoin vaults is so immense that it will continue to grow exponentially.

Like all financial instruments, creating a healthy derivatives market will significantly enhance spot liquidity. Complaints about poor liquidity in the altcoin spot market may soon become a thing of the past.

3. What are the next developments for DOVs?

The appeal of DOVs lies in the astonishing simplicity of the model. But this is just the beginning.

First, the strategies currently offered by the vaults are just ordinary puts and calls, but these can and will become increasingly complex. For example, more complex options structures can better utilize collateral and amplify base yields. Over time, it may even be possible to offer more complex options (exotic options) through the vaults. These strategies could even shift from purely options-related tools to include more complex nonlinear products, which would, of course, bring additional risks.

Furthermore, the options contracts traded in the vaults can be tokenized and traded in the secondary market via order books or RFQ. With a sufficiently large TVL and multiple vaults, especially if various DOV protocols can interoperate, DOVs could be used as a complete Deribit exchange, with a wide range of contracts and various types of structured products that have active trading volumes. The realization of this vision would be incredible, a mature derivatives market traded entirely through smart contracts!

Finally, DOVs will not only change the way options and structured products are traded. It will also change the way asset management is conducted. Investors no longer need to be accredited investors with minimum investment limits of millions of dollars to access institutional-grade trading strategies. Any investor with a dollar can participate in DOVs and enjoy the extraordinary returns brought by complex strategies, as well as the best risk-return profiles they choose.

Most importantly, DOVs discard the typical hedge fund 2/20 model. Investors only need to pay a small fee, or even no fee at all. Because all participants will receive token incentives for investing in the vault and providing liquidity.

This is the way token rewards should be constructed; it is a mechanism that promotes disintermediation and is part of DeFi innovation. Not as a primary source of yield. I would even say that DOVs are the true expression of DeFi value and will become the convergence point between the current DeFi community and the Tradfi world.

4. A quick overview of existing DOV protocols:

Ribbon.Finance: The pioneer of DOVs. Built on Ethereum, with a TVL close to $200 million, primarily in WBTC and ETH. They also offer AAVE, AVAX, and STETH. Ribbon uses Opyn and Airswap for settlement and Gnosis for on-chain auctions.

Thetanuts.Finance: An emerging DOV focused on multichain operability, currently available on Ethereum, Binance Smart Chain, Polygon, Fantom, and Avalanche, and will soon appear on most EVM-compatible chains like NEAR Aurora, Boba, and Solana NEON. In addition to WBTC and ETH vaults, they are also heavily promoting altcoins, launching a $10 million ALGO vault and a $2 million LUNA vault. They currently also offer ADA and BCH as well as BOBA, ROSE, and NEAR. Thetanuts manages settlements within the protocol without third-party dependencies.

StakeDAO: Currently operating on Ethereum, with plans to provide services on Polygon in the future. Its passive strategies involve staking stablecoins and tokens or providing liquidity across multiple protocols for rewards.

Other notable DOVs:

Solana Chain: Friktion.Finance; Katana Finance; Tap Finance

Polygon Chain: Opium.Finance, SIREN Markets

Avalanche Chain: Arrow Markets --- offers call and put spread vaults. Also provides a unique price oracle for settlement written and hosted by the protocol.