Best Practices for Building Decentralized Option Vaults - Pt 2

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Published On

October 11, 2022

In the part 1 of this article the author introduced the concept of Decentralised Options Vaults and their importance in the Crypto Ecosystem. The second part of the article explores the Do's and Dont's of DOV's.

What Should BUILDers Keep In Mind?

Adoption of ERC-4626

The main problem developers face while building tokenized vaults is the integration of different yield bearing tokens. For example, in a situation where you want to build a DeFi app which requires integrating the tokens of each protocol, you will need to research each one, know their model of accruing yields, and adjust it into your code base. If you want to integrate vDAI of Maker DAO; stETH on Curve; and so on, you will need to understand the peculiarities of their smart contracts and build custom solutions to successfully integrate each of them into your DeFi app. 

Apart from how stressful and time-consuming this process of integrating different yield-bearing tokens can be, it also increases smart contract risk because of potential errors. Developers will need to spend more time checking for potential loopholes in the adapters, and in some cases, they might even need to outsource it to smart contract auditors, which can be costly. This is more important now that attackers are breaching the integrity of a lot of protocols and DeFi apps. Hence, the creation of the ERC-4626 standard.

What exactly is ERC-4626? It is a standard API for tokenized yield bearing vaults that represent shares of a single underlying ERC-20 token. The vault standard introduces the concept of shares as a way of getting fractional ownership out of the entire pool. These shares refer to yield-bearing tokens. When users put any funds into the vault, the deposit function triggers the smart contract to mint a corresponding amount of shares to the depositors. The withdrawal function helps owners burn shares in exchange for assets. The ERC-4626 is a compatible extension of the ERC-20 standard. As a result, most of the usual variables, events, and functions that are applicable in ERC-20 token contracts still work with the ERC-4626 vault standard.

While there are a couple of prominent token standards at the moment, the DeFi world still has a recurring problem regarding tokenized vaults. DeFi aggregators have always found it quite stressful to aggregate several yield-bearing tokens because there was no standard. But now ERC-4626 makes it possible to have details of yield-bearing tokens with one API call. 

The standard makes the integration of protocol easier and less prone to errors. Since there is a common standard that you can integrate, there is no actual need to build separate adapters any longer. It quickens development and enhances composability. Similarly, it reduces cost because builders no longer need to get auditors to help with their adapters and interfaces. Most importantly, ERC-4626 enhances security among dApps and yield aggregators that are dealing with yield-bearing tokens.  

Who uses this standard? Protocols such as Balancer Linear pools, Yearn finance, Yield protocol, Alchemix v2, Convex finance yield pools, and more are already using this protocol actively. The problem of going the extra mile to enhance the security of DeFi applications with yield-bearing tokens is solved—to a large extent—with the introduction of this baseline standard. Use of composability and interoperability among various DeFi protocols will increase in the next couple of years. It is even possible that this standard will be a launchpad for building and shipping completely new products in the DeFi ecosystem.

Should be in line with existing successful DOV’s strategies

The appeal of the DOVs emerges from its seamless accessibility and simplicity for the user. Investors simply ‘stake’ their assets into the vaults which are automatically deployed into option strategies.

The strategies deployed thus far have been selling covered call and put strategies (which we discussed above) providing the highest base yield available in Defi (averagely 15–50%). On top of that, token rewards are distributed, providing an even higher yield for users. In some instances, the collateral in the vault earns staking/governance yields as well, creating three sources of yield in a single vault. This triple layer of option premiums, token rewards, and staking yield creates a significantly high and – more importantly – sustainable yield that is unprecedented in Defi.

Another major problem DeFi must solve is non-linear liquidations. Even centralized exchanges like Deribit manage non-linear liquidations with some difficulty. For the liquidation of large option portfolios, the delta (or spot risk) is managed first by executing a perp/futures position against the portfolio. The other greeks in the portfolio (non-linear risk) are then systematically liquidated over time with an active involvement by the intermediary.

By using a hybrid DeFi model where investment, collateral management, price discovery and settlement occur on-chain while non-linear risk management is performed off-chain, DOVs provide an elegant solution to this problem. All option contracts traded through DOVs are fully collateralized which eliminates the need for liquidations completely.

Refine Options Trading Strategies to Make Them More Dynamic

All DOVs typically only offer covered calls or protective puts and they will trade on these options strategies on a weekly basis regardless of market conditions. While these strategies may minimize risk, DOVs are still dependent on market conditions.

Put simply, covered calls are riskier during bullish markets while protective puts are riskier during bearish markets. Covered call strategy faced a significant loss (especially in early 2021) when ETH jumped from $740 to $1200 in less than a week. Black swan events like this tend to be infrequent but significantly erode the strategy’s profitability. When the contracts being traded through these strategies expire ITM, it is the investors’ capital at risk, resulting in extremely low APYs and even principle risk.

However, these risks can be counteracted by simply accounting for market conditions before trading for strategies. DOVs should analyze the market through discretion, considering the option type, strike, maturity, and market factors, to trade rather than just employing automated strategies. For example, to predict extreme events, vaults can analyze the ETH price/option strike ratio. If the ratio is greater than 1, it indicates the sold call option is ITM whereas a ratio less than 1 indicates the option is OTM.  This quantitative analysis can be done through a combination of oracles, on-chain data analytics, and well-built code. 

If DOVs begin analyzing options and the market before trading through covered calls or protective puts, it may result in higher profitability for everyone!

Illusion of ‘Good’ Yield is ‘Bad’

Some of the protocols selling certain strategies in DOVs have been found to advertise fake high yield to make their vaults attractive. Who doesn’t like double digit APR in a risky environment? There are a number of ways to fake/tweak the numbers from excluding the loss from in-the-money weeks to only calculating the yield as an average of past few weeks (which necessarily smoothes any downfall).

Hence there’s a need to do away with the tradition of faking the actual numbers. True yield along with all the associated risks must be flashed on the UI to make the whole process transparent for investors. Doing otherwise is simply predatory.

Integrate Cross-chain Liquidity

While “omnichain” or “crosschain” have become buzzwords for the NFT-enthusiasts, they are especially important in the context of DeFi. With capital in DeFi split across so many chains resulting in liquidity fragmentation, it’s necessary for any DOV to be functional across chains to their best extent.

There are two ways a DOV can be cross-chain: deploy on other chains or make use of cross-chain liquidity aggregators and Layer Zero. While deployment is typically preferred by most DeFi protocols, it could be expensive owing to the number of virtual machines and various deployment costs. Instead, making use of protocols like Layer Zero or 1Inch would allow for DOVs to maximize their capital and consequently their profitability.

Allow for LP Tokens Deposit

Most DOV deposits are typically single-asset: ETH, MATIC gOHM, etc., and there’s nothing much to it. If DOVs would allow for users to deposit their LP tokens (Polysynth, for example), this would allow for users to yield farm while unlocking liquidity for them to earn from option premiums as well. A protocol named Rage Trade approaches the deposit of LP tokens quite similarly through their “deep liquidity” functionality – LP tokens are used to dynamically unlock liquidity for perp trading as asset prices (and perp prices) increase and decrease.

Conclusion

The appeal of DeFi option vaults is tremendous. The current strategies that the vaults offer are just vanilla puts and calls, but these will gradually become complex in the future. The product's structure will make it very difficult to use the vaults as a hedging tool. However, the protocols will be very approaching for bootstrapping liquidity for the options market, eventually making decentralized options more viable.

DOVs are an essential step toward democratizing finance for the masses. They also play a leading role in increasing demand for organic yield. Therefore, they address the issues of the unsustainable and circular yields that DeFi currently faces. Many of us have imagined the allure of AI and tech making their way into the financial industry – most people even believe the work of analysts and researchers to become obsolete as technology continues to develop. When you combine the benefits of automation in finance with decentralization – you get a DOV.

About Paradigm

Paradigm is a zero-fee, institutional liquidity network for crypto derivatives traders across CeFi and DeFi. The platform provides traders with unified access to multi-asset, multi-protocol liquidity on demand without compromising on execution preferences, costs and immediacy. Paradigm’s mission is to create a platform where traders can trade anything, with anyone and settle it anywhere.

Paradigm has the largest network of institutional counterparties in crypto with over 2,000 institutional clients trading over $10B per month, including hedge funds, OTC desks, lenders, structured product issuers, market makers and prominent family offices.

About Polygon DeFi researchers

This research article is authored by Polygon DeFi researchers: Eshana, Akhil, and 0xlol in association with Paradigm Trading. Eshana is a quantitative finance research intern at Polygon, and is a finance and computer science major at NYU. Akhil is a DeFi research intern at Polygon, and studies finance, math and computer science at NYU Stern. 0xlol (Twitter, Github) heads DeFi research communications at Polygon, with their research interests in DeFi derivatives, Web3 Infra, and Layer 2 Scaling Solutions.

Additional Readings on DOVs:

DeFi Structured Products. Finance is complicated. There is no way… | by BenKaplan | Coinmonks | Medium

How to use DeFi Option Vaults (DOV): risks and return | by Andrey Belyakov | Coinmonks | Medium

Quantifying Risks of DeFi Options Vaults | IV League DAO

The Inner Workings of DeFi Option Vaults (DOVs) - Delphi Digital

A Deep Dive into Options Products in DeFi | by Juan Pellicer | IntoTheBlock | Medium

Overview of Options Vaults | Messari

A Quantitative Analysis of DeFi Option Vault Strategies

https://twitter.com/QCPCapital/status/1469963752623665152?t=CKZKKJZuZ9BmS4bGRSN7Rg&s=19

https://twitter.com/joey__santoro/status/1478489634300588032?t=DLCBrn1cEnBu6ecAlwEX3Q&s=19

https://twitter.com/two_prime/status/1513972960746483713?t=Wiyg3JyVjAA-S0PWxzuP8g&s=19

https://twitter.com/poolpitako/status/1388279685885440001?t=81SUbqYyVGG21cAmg9Gquw&s=19

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Polygon Technology
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