Why is the development of DeFi options protocols generally poor?

Original Author: Rapolas, Zee Prime Capital

Original Title: 《A deep dive into DeFi option protocols》

Compiled by: Eva, Chain Catcher

If you have read any articles about options before, you might now know that there are serious issues with options in TradFi. In fact, in the U.S., the notional value of stocks represented by daily options trading has surpassed last year's spot for the first time in history. Other derivatives (futures, swaps, and others) have long exceeded the market capitalization of stocks combined.

Options attract many different market participants, as they can unlock investment strategies that spot cannot provide. Here are several reasons why people buy or sell options:

• Portfolio protection (insurance). Sell assets at a price above the market;
• Intrinsic leverage. Options provide a higher notional value than spot;
• Trading structuring. Express views through the most cost-effective and/or capital-efficient structures, leading to risk/return;
• Income. Sell options and collect premiums in exchange.

The massive growth of DeFi has been accompanied by expectations of "institutionalization." With new products being built by blockchain developers and TradFi navigating compliance minefields, on-chain opportunities for options, derivatives, and structured products are becoming increasingly apparent. However, compared to products from centralized exchanges like Deribit, the on-chain drivers for options today are negligible. The following chart shows the open interest (OI) of options, providing a conclusive idea about the depth of available liquidity:

Compared to on-chain protocols (which typically offer 1-2 short-term expirations and 3-5 strike prices), on-chain options not only have liquidity that is easier to obtain off-chain, but they also have a broader range of expirations and strike prices.

In this article, we reflect on the overall trends in the on-chain options space, existing pain points, and how to improve options products. It is clear that founders understand the size of the incentives. We have recently seen explosive growth in options protocols, and more options protocols are expected to launch in the coming months. It is evident to us that winners are yet to be established.

Not all options are created equal

In the past 12-18 months, the situation for options has changed dramatically. At the beginning of 2020, Hegic was the dominant options protocol attempting to create liquidity pools capable of selling put and call options. To this day, various so-called liquidity pools (including AMMs), order books, structured products, and their subgroups have iterated variously, naming them sustainable yield products. Each category has at least a few protocols running or in development. The total options TVL is about $1 billion, primarily available on Ethereum, Arbitrum, and Solana.

We summarize the state of on-chain options as follows:

Perhaps unsurprisingly, structured products have found the most successful product-market fit to date. These protocols, often referred to as Vaults, allow users to sell volatility at a premium (i.e., underwrite call options or protective put options), which some view as an alternative to liquidity mining, for better or worse. Coupled with some token rewards, in certain cases, you can see APYs reaching triple digits. After the initial deposit, users do not need to take any action, as options expire (mostly weekly) and strike prices (relative to spot) are pre-selected and automatically rolled by the protocol.

While the most popular underlying assets are ETH and BTC, there are also available products for AVAX, SOL, and a few other tail assets. These structured products have accumulated a TVL of $600 million, with Ribbon Finance leading the category. Notably, most of them largely use the same off-chain market makers to auction the options they sell, thus obtaining premiums. We expect that long-term winners in the structured product category (as defined today) will be able to offer the following products:

• Community-initiated and led products with unique returns.
• The most competitive fee structures.

One trend observed this year is that a significant sell-off from structured product protocols has led to a decrease in short-term implied volatility (as off-chain market makers buying options must hedge by selling similar options on Deribit). This suggests that there may not be enough natural demand to absorb the growing TVL in structured products, a situation that may persist as the product presents a simple and attractive yield proposition to users. Some protocols have begun to address this issue, allowing anyone to bid on-chain, competing with market makers on pricing, which is a welcomed development.

The following chart shows that ETH's implied volatility has been declining since mid-December. We believe this is due to the drop in actual volatility and the sales driven by strong growth in structured products in Q4 of 2021.

Selling options close to expiration has also made the implied volatility term structure steeper. This is because market makers specifically sell short-term options to hedge the weekly purchases from structured products.

Worse for structured products is the observed decrease in volatility around the weekly premium auctions, as market participants know in advance that there will be a large number of options sold, pushing implied volatility down and reducing the yield for structured product users. The protocol leaves an open question: should it take on more risk (i.e., underwrite options closer to ATM) to compensate for the compressed yields, or should this market force naturally balance the supply and demand of volatility sell-offs? The Friktion team has begun to address this issue, attempting to capture higher implied volatility by using different weekly auction times (depending on the asset).

In addition to the structured products mentioned above, we also define a set of unique protocols that we call sustainable yield products. Protocols like Opyn, Brahma.fi, Primitive, Friktion, and Vovo vary widely, making it difficult to come up with a unified term. However, these protocols are providing unique returns or allowing principal protection while relying on perpetually sustainable sources of yield. The applications developed today, we believe, will greatly expand in the coming year:

• Hedged LP positions;
• Hedging options risk (against market makers);
• Perps funding payments as yield products;
• Selling synthetic options through concentrated LPs via AMM;

These types of products have the potential to unlock use cases at the protocol-to-protocol level, where structured products are applied to the protocol's treasury for risk management and capital efficiency purposes. These protocols are relatively young and niche, but Opyn's squeeth (squared ETH) product has found a suitable market position and is one of the building blocks for the aforementioned use cases. Products like squeeth actually consolidate liquidity rather than dispersing it across different option strike prices and expiration dates.

Next, let's look at order book protocols, which attempt to establish options on centralized exchanges. These require high-throughput blockchains to ensure cheap and fast execution, making Solana the preferred choice for this category. Zeta Markets and Psyoptions aim to provide options trading venues with under-collateralization and cross-margining. Additionally, order book protocols are important infrastructure in the options space, as structured products are using them to mint and settle options. We believe that, in the long run, winning products in order book protocols will be able to:

• Provide a full suite of decentralized derivatives, mutually reinforcing liquidity and price discovery while ensuring under-collateralization and cross-margining;
• Ensure the highest on-chain liquidity (currently lacking, but this liquidity is being addressed as private investors join as on-chain market makers);
• Maximize the utility of minting and settlement infrastructure by allowing modularity at the top components (exercise, expiration, European vs. American options, cash vs. asset settlement, etc.).

Finally, liquidity pool protocols are striving to quote and underwrite on-chain options without the help of order book protocols or off-chain market makers. Dopex, Premia, and Hegic can be seen as advanced Vaults that have made some improvements in quoting options and selling them to on-chain buyers. These protocols have yet to succeed, growing to over $100 million in TVL. There are still obstacles:

• Funding pools can only underwrite options, not buy them back;
• Liquidity providers cannot choose the strike price at which their options are underwritten;
• Option pricing ignores the utilization rate of deposits in the funding pool;
• Liquidity providers are exposed to the underlying asset, meaning they do not hedge like true market makers.

These products go beyond structured products (Vaults), but ironically, they are at a disadvantage in finding product-market fit.

Lyra, Primitive, Pods, and a few others have taken alternative liquidity pool approaches. These teams are building decentralized market makers or AMMs for options. We see this group ultimately competing with Solana's order book protocols, so the winning products should have a value proposition centered around capital efficiency (under-collateralization) and options pricing.

Supply and Demand: The Failures of On-Chain Options

While the growth of options in DeFi has been faster than other products (until recently), it has not yet succeeded when looking at user numbers, the volume of options versus spot, and the previously discussed differences with on-chain OI. To explain this issue, we first look at the sources of options liquidity, then break down the logic behind the supply and demand for options products.

Providing Liquidity: Traditional Market Makers On-Chain

Traditional market makers need a single venue with the deepest available liquidity, offering multiple derivatives (options, perpetuals) and allowing cross-margining for collateral. There are several protocols on Solana leveraging this, and we expect them to gain significant traction in the coming year, especially as they integrate with Solana's structured products. These projects are either not yet launched or have only recently launched, and we believe this approach still awaits market validation.

Providing Liquidity: DeFi-Native Market Makers (Decentralized Market Makers and Options AMMs)

We see several pain points for providing on-chain liquidity for options:

• By design, most options expire worthless. This means LPs will tend to face 100% losses most of the time. To mitigate this, protocols need to protect LPs at the expense of capital efficiency, available liquidity in AMMs, and price discovery.
• High gas fees. Most options protocols are built on Ethereum, where L1 gas prices have increased. Given that premiums have relatively low dollar values, options are particularly sensitive to gas fees.
• Decentralized market makers must have hedging. For a liquidity pool to underwrite options and be able to sell both ways, it must hedge. The technical implementation of such products may be the most challenging among all options protocols, as it must dynamically calculate risks for its LPs and price options accordingly, while also finding ways to hedge risks through spot or futures. Ideally, such products would be built on futures products on scalable blockchains and would not have settlement issues at different stages of executing trades.

Now let's look at the supply and demand situation for options products once market makers have established liquidity.

Selling Using Existing Liquidity

We tend to categorize structured products in this category, as they aggregate existing demand for yield (selling volatility), package it, and then sell it. Our only caveat is that these options are sold off-chain, as there is currently not enough on-chain liquidity.

Buying Using Existing Liquidity

Today's on-chain options products are more seller-oriented than buyer-oriented. Until recently, we have only seen one or two buyer-oriented products that leverage composability with other DeFi primitives. For example, offering options to hedge LP positions is a way to create natural demand from options buyers and build incremental TVL.

Existing On-Chain Options Products Fail to Address the Following Issues:

• DeFi users have a high-risk appetite.
• The main reason options have become popular among retail investors is leverage.

Returning to the earlier point, for someone to buy highly speculative, deep OTM call options on tail assets (i.e., buying convexity on tokens that may parabolically rise in spot), there must be someone underwriting those options, whether traditional or DeFi-native market makers. The options available for purchase today are more about providing insurance than exposing people to exponential upside returns.

Zee Prime's Options Conclusions

Conclusions related to on-chain options and the broader structured products:

• Order books vs. decentralized market makers. We believe these two will not coexist. Order books will be pushed forward as they can provide cross-margining and under-collateralization, which are necessary conditions for traditional market makers to bring deep liquidity. We all favor seeing these issues addressed with DeFi-native approaches, but today most liquidity pools are promoting earning APY from capital without addressing the risks of being unhedged options underwriters. These types of options underwriters do not earn uncorrelated returns like market makers. Unless under-collateralization (through insurance pools, liquidation) and hedging (through spot, futures, or multiple options legs) are provided to liquidity providers, liquidity pools will not be able to compete with order books. We see Lyra (hedged liquidity providers and low collateral) and Primitive (synthetic options in AMM, where liquidity tokens can be used as collateral, thus improving capital efficiency) as two different approaches to successfully challenge order books.
• All structured product protocols will ultimately establish sustainable yield products. Selling options premiums to generate yield is not a long-term strategy. Yields will decline as more TVL chases the same batch of market makers, who need to transfer that risk to others. More products will be built to leverage native yield sources from cryptocurrencies (staking, perp funding, synthetic options premiums as exchange fees for AMMs, etc.).
• On-chain options will be adopted as they become more closely integrated with other DeFi use cases. AMMs, money markets, and perpetual futures markets can drive their own liquidity and adoption by adding options as risk management tools. This will create natural demand for on-chain options rather than trying to buy weekly calls and puts that are close to spot.

And thoughts on what options products or use cases could be built next.

• Volatility as a product. The introduction of Power Perpetuals should allow for the establishment of on-chain volatility products using on-chain oracles (similar to the VIX in TradFi, which measures the implied volatility of underwriting options prices). Since perpetual contracts are similar to perpetual options, their pricing considers the entire options chain rather than a single expiration date, thus aggregating the entire open interest. Since dynamic perpetual options have no expiration date, a volatility pricing tool that does not exist in TradFi or off-chain should be possible to create.
• Combining hedged selling with stablecoin lending for cash-settled options. Sellers of covered call options who want to earn yield while maintaining exposure to the underlying asset (like ETH) can use this collateral to borrow stablecoins. If the price of the underlying exceeds the strike price at expiration, the yield can be used to settle the options contract.
• Warrants replacing liquidity mining. We see a scenario where protocols can replace traditional liquidity mining with token warrants (smart contracts that give warrant holders the right to purchase tokens from the protocol treasury at a predetermined price). This is similar to holding OTM call options on the protocol's tokens. Warrants can only be exercised when a certain token price is reached, and there will be a very low exercise price, providing immediate profit to warrant holders when the exercise conditions are met. This model offers several benefits to the protocol and its treasury:

1. It provides growth space for the tokens before the warrants can be exercised, leading to higher valuations and deeper liquidity, with the corresponding tokens being sold by employed capital. Ideally, this selling dynamic will be absorbed by the liquidity established beforehand, curbing the periodic sell-off of incentive tokens.
2. The treasury is effectively raising funds from users, as the warrants are exercised at a pre-agreed price.
3. If the predetermined token price is not reached, the warrants can never be exercised, and they expire worthless. The protocol retains its token supply and can use it as rewards in the next iteration of the project.

Finally

Options, structured products, and the broader derivatives space are complex. Nevertheless, it is clear today that winning products in this field are yet to be established. Options will take longer to take off compared to other DeFi applications, but as blockchain scaling issues are resolved, more teams will be able to test and implement their ideas.

We are eager to see DeFi-native options market-making approaches win, as this would truly democratize the space, which has historically been inaccessible to retail due to its inherent complexity. The best protocols in this category attempt to consider the tasks of traditional market makers from first principles and then use DeFi-native tools to witness their implementation.

We are also willing to help our elders configure structured products that will provide higher (and sustainable) yields than the TradFi tools sold to them by MBA-trained consultants.

The complexity of DeFi (for better or worse) is advancing, more interdependencies are being created, and founders and investors are patching together more products.