New Species of DeFi: The Exotic Derivatives Protocol Cega

Author: Beichen/Chain Teahouse

In the past two years, from DeFi to NFT, Gamefi, Web3, DAO, and the metaverse, the entire crypto space is undoubtedly in a phase of cosmic explosion.

However, this does not mean that every track mentioned above can maintain the growth rate of the past, although people always make long-term judgments based on recent experiences, especially in terms of investment.

For example, in the NFT collectibles space, the market's driving force is the narrative that can resonate with investors and the confidence it inspires, allowing the market to far outpace the development of the infrastructure composed of interested collectors, excellent creators, and traders.

But there are still many opportunities in DeFi. Although there are already various mature financial infrastructures such as exchanges, lending platforms, and stablecoins, these are still far from meeting real needs. For instance, derivatives that can hedge risks and access to these complex derivatives without thresholds.

Here we introduce a very novel derivative protocol, Cega, which is innovative not only because it has not yet launched its testnet (scheduled for late March) but also because Cega is an exotic derivative protocol.

From Exotic Derivatives to FCN

Exotic derivatives are those that are more complex compared to conventional derivatives (such as European options and American options), hence the term "exotic."

Conventional derivatives are always similar, while exotic derivatives each have their own differences.

Exotic derivatives are a collective term for a series of different complex derivatives, from pricing to hedging methods to liquidity, the combinations are like a kaleidoscope. You can think of a single exotic derivative as a structured product.

You can experience some common exotic derivatives through the following------

Packages are combinations of various options and spot assets, compound options are options based on options, chooser options allow the selection of whether the option is a call or put option within a certain period, barrier options are options with trigger prices for activation or deactivation, lookback options are priced based on historical highs or lows, and Asian options are priced based on the average price over a period of time…

Despite the variety of these exotic derivatives, they share the common feature of having both higher potential returns and downside protection.

"When the market fluctuates by 10%, users can sometimes lose their principal. Crypto derivatives and cryptocurrencies are still generating high returns, but I think we also need something safer, and that's my view on Cega," said Toyosaki from Cega.

Cega's first exotic derivative product is the fixed coupon note (FCN), which allows investors to earn higher yields with a lower probability of losing principal (and with downside protection).

The specific implementation is relatively complex but not impossible to understand; let's break down the FCN step by step.

The FCN sets a price fluctuation range for the tracked asset (e.g., Google stock) and then sets an interest rate. Next, we observe its performance over the entire product duration.

If the price fluctuates within the pre-set range, it acts as a fixed investment product.

If the price rises above the pre-set sell price (referred to here as the knock-out price) during this period, it will automatically sell for profit, effectively ending the product early.

If the price falls below the pre-set buy price (referred to here as the knock-in price) during this period, it will automatically buy the stock, but the product does not end here; there are three more scenarios------

1. If the price subsequently rises back and exceeds the sell price, it will profit and end early, just like the previous scenario.

2. If the price subsequently rises back but does not exceed the sell price, the investor will retrieve their principal at maturity.

3. If the price does not rise back, the investor will retrieve the stock at the buy price at maturity.

So while there is a risk of loss, the FCN is clearly more reliable than retail investors chasing highs and cutting losses, with a higher capacity to withstand volatility.

If the price range is set reasonably, the probability of capital preservation and profit is still quite high, unless the investment target falls sharply from the moment of purchase and drops below the knock-out price.

Toyosaki and Her Cega

The FCN product functionality that Cega aims to create is similar to the above description; in short, users are unlikely to face the risk of principal loss and are more likely to achieve repeatable yields.

However, Cega is ultimately a DeFi protocol and will reconstruct the logic of FCN in a DeFi manner, just like other DeFi structured products we have previously introduced, layering the risks.

According to the white paper, Cega's FCN investors have three options: 1. high risk, high return; 2. medium risk, medium return; 3. low risk, low return.

This may sound like nonsense, but according to the white paper V2, the minimum yield calculation exceeds 40%, although the logic behind this conclusion is currently unclear.

To be honest, the mathematical and financial engineering difficulties involved in the pricing models behind exotic options are too high to comprehend…

"We actually have to perform various mathematical simulations of the distributions of different markets, and only through random simulations of 10,000 to 20,000 different scenarios can we finally create the option prices."

Cega plans to launch its test version on the Solana devnet later this month and officially launch in the second quarter, soon becoming compatible with the Ethereum ecosystem.

More details about the product await the launch of the test version, but what is known so far is that the FCN fees are paid daily, and users are more likely to short volatility and long market positions.

Cega's founder is UBS derivatives trader Arisa Toyosaki, who began paying attention to the crypto space in 2016 and considered launching a crypto derivatives platform but was dissuaded by professionals in this field and traditional finance—because they felt it was too early.

Then during the "DeFi Summer" in 2020, she considered launching an exchange that offered simple call or put options but later realized that her true interest lay in the field of exotic derivatives.

Toyosaki said, "I find exotic derivatives fascinating; you can hold trading positions not only in the case of rising or falling but also based on volatility (i.e., the magnitude of the rise or fall). In short, you can bet on so many different types of views. So I want to see how I can contribute to the growing crypto market with my expertise in derivatives."

The entire Cega team consists of 4 full-time and 3 part-time members, including a quantitative trader with a PhD in stochastic volatility and a trader with experience in pricing exotic options.

Recently, the Cega team completed a $4.3 million financing at a valuation of $60 million in just two to three days, led by Dragonfly Capital, with participation from Pantera Capital, Coinbase Ventures, Alameda Research, and Solana Ventures.

Currently, the entire decentralized derivatives field is still in a very early stage, accounting for less than 3% of the entire DeFi ecosystem.

The previous timing for development was not right, largely because holding spot assets during a bull market provided considerable returns, but in the future, there will be more demand for shorting, hedging, and capital preservation.

One more point that is easily overlooked is that previous DeFi innovations mainly occurred on Ethereum, which is not suitable for high-frequency trading, while the development of emerging public chains like Solana can support the emergence and popularization of more DeFi innovations.

Cega is currently the first decentralized derivatives protocol for exotic derivatives in the DeFi space, making it very worthy of attention.

"DeFi has gone through a process where a team created an innovative breakthrough financial primitive, which in turn stimulated the creation of an entirely new product category and developed the entire market," commented Tom Schmidt, a general partner at Dragonfly Capital, on Cega.