Derivatives in DeFi: Present and Future

The blockchain industry is always innovating and the derivatives market for cryptocurrencies is no different. A key innovative trend for crypto derivatives that I have observed is to produce new derivatives that function in unique ways that traditional institutions have failed to issue because of bureaucratic barriers. We saw this in the creation of perps, or perpetual swaps, that give investors exposure to spot markets through derivatives that, unlike futures and options, do not have to be rolled over.

This trend is especially and primarily strong in DeFi, as DEXs are free to experiment and create a variety of derivative products that centralized exchanges are unable to offer due to regulatory concerns or complacency with the current crypto derivatives market. Let’s dive into the some of the most promising and unique projects that exist and are being proposed in DeFi:

Power Perpetuals

The purpose of power perpetuals boils down to exposure and convexity. Because of the mechanism that power perps use to leverage, contracts with a power greater than one will have positive gamma. This means that holders of the contract see returns faster as the price of the underlying asset moves in their favor and lose money slower if the prices move in the opposite direction to their position. To visualize and understand this, consider the return of a power perp to be represented as the equation (1+r)p where r is the power perps price movement and p is the power determining gamma:

Figure 1. Numerical description of multiple power perpetuals and their price movements

This allows the power perp to give a higher upside and limits downside losses the higher the power of the contract. As the price of the underlying asset moves at a higher percentage, the gains are larger and the losses for a similar movement are smaller. The power increases leverage for the investor and can significantly increase gains while providing some protection against losses. An example of power perpetuals that offer unique advantages as opposed to perps and other derivatives is Opyn’s Squeeth. Squeeth offers positive gamma, no liquidations when holding long, and composability so it can be traded or used as collateral. DeFi protocols that offer power perps offer unique speculative and hedging strategies that traditional markets will never match.

Structured Products in DeFi: DOVs

In the current crypto derivatives market, structured products are used to give investors exposure through highly customized and safe investments. An example of a crypto structured products is the ProShares BTC Futures ETF which tracks the CME BTC Futures price to generate yield for investors. Products like these assure investors and play a large role in portfolio diversification and asset management for individuals and institutions broadly.

In order to create and sell reputable structured products in the United States, companies must have SEC approval. This has led to a roadblock against DeFi, as the SEC requires the assets in structured products to be from centralized and regulated exchanges due to concerns surrounding price manipulation. This has resulted in a lack of diversification for structured products in crypto as all SEC-approved structured products only track BTC derivatives and include products from centralized exchanges.

DeFi products have stepped up to the plate, offering unique structured products with risk-adjusted yield without the need for intense regulatory oversight. These structured products are known as DeFi options vaults. These vaults allow investors to stake their assets in a vault which will then deploy their stake to a specific options strategy through smart contracts. The investors then earn yield from the premiums that options buyers are paying and by earning native tokens through the vault itself which they can later choose to re-stake.

These have been innovative products because, prior to options vaults, you could only trade options if you were an accredited investor who had access to options on crypto through OTC trading or if you were in an unregulated environment where Deribit, which is the leading crypto options exchange, was accessible. Thanks to DeFi options vaults, any investor can enter into a vault and earn yield from an options strategy the same way centralized venues offer yield through structured products.

Figure 2. Top DOVs by TVL.

DeFi options vaults offer a unique opportunity to provide liquidity for altcoin options and make a market to narrow their spreads. As mentioned, centralized exchanges have historically been the center point of volume for crypto derivatives and most of the open interest for crypto derivatives is focused on Ethereum and Bitcoin. Altcoin options, such as those on Solana or Avalanche, have suffered from the illiquidity positive-feedback loop mentioned above, where institutions need liquid markets to trade but without institutional capital it is difficult to escape illiquidity. Options vaults are currently bringing liquidity to altcoin markets and are the largest trading venue for altcoins. This offers an opportunity for altcoin markets to escape the illiquidity feedback loop, as an initial capital injection to gain liquidity is coming from these DeFi vaults that are driven by retail investors, not institutions.

Historically, this initial injection of capital has worked for crypto derivatives. When ETH options were offered in 2020, they were illiquid and had wide spreads. After initial investments from QCP Capital, ETH options gained liquidity and market makers came in resulting in ETH options volume growing to be proportionally larger. The opportunity for altcoin derivative markets to scale and create value is much more probable given that altcoin vaults will continue to provide significant liquidity and reduce overall volatility. This growth is good because it provides more opportunities for derivatives markets to gain open interest and give DEXs a competitive edge against their centralized counterparts.

Panoptions: A Theoretical Case for Uniswap v3 Concentrated Liquidity Options

Figure 3. Panoptic options payoff curve variations.

Panoptic also introduces a novel, oracle-less pricing model known as a “streaming premium”, where the price of a panoption is determined by continuously integrating the derivative of an option’s current value on Uniswap respective time. This eliminate the need for expensive oracles and allows the price of an option to be path-dependent rather than all up-front and fixed, saving investors more in fees than alternatives like everlasting options that charge consistent funding rates.

Figure 4. Panoptic options fee accumulation for ITM, ATM, and OTM options

It is important to note that these options never expire and therefore act as a perp. However, they have strike prices and premiums are collected in different ways. Anytime an option is out of the money, or the price of a token pair is outside of the LPs ticks, the position does not charge fees. This means ITM and OTM calls and puts are not being charged a funding rate. Rather, only when an option is ATM or the pair is trading between the LPs ticks does the holder of the option pays a premium. This covers the LPs losses from impermanent loss (which in reality should be called permanent loss) and the longer the position remains ATM, the more likely an options holder will sell their position.

You may be wondering, if the options never expire what stops people from buying a call on a token pair like ETH/USDT at 13k and holding it for a decade before exercising when the price of ETH/USDT is larger by orders of magnitude? Well, in the same way that lending protocols have created novel technology to liquidate undercollateralized loans through smart contracts, panoptic protocol gives options writers the ability to force exercise the holder of an option if they get too deep in the money. There is a lot of game theory involved in whether or not an options writer will force exercise. If an LP believes the price of the token they are LPing for will go down and back into the ticks, they will not force exercise and continue to accrue fees. If they think the holder of the option is about to break against the fees accumulated and the price of the token pair will not go back down, they may force exercise to protect themselves. This is an area of study that has not had much focus and it would be interesting to see some payoff matrices built around an options strategy in panoptic.

To learn more about panoptions and their technicalities, read the whitepaper here.

Conclusion

In DeFi, the potential to create new derivatives that offer unique opportunities for investors to hedge and speculate is stronger than ever. Panoptions are one of many proposed derivatives that may soon become commonly traded in the market. As innovations and research continue to proliferate during this time, opportunities to revolutionize the way crypto derivatives are traded continue to grow.

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